Lee Sharpe looks at the advantages – and some of the perils – of the director’s loan account.
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For more in depth discussion on this important area of business taxation, please see our newly released guide, Directors' Loan Accounts Explained.
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This article will set out the case for using the director’s loan account (DLA) – with care. When referring to a ‘director’s loan’ or ‘DLA’, I mean a loan to a director who is both an employee and a shareholder in the company.
Certain tax aspects of DLAs arise because the loan is between the company and its employee, while others arise because the loan is between a small company (a ‘close’ company) and one of its shareholders. While directors can (and often do) lend money to the company, in this article we are considering loans from the company to the individual.
Why are DLAs useful?
First and foremost, a loan to an individual is not income. Generally, the individual cannot be taxed as if it were income, despite what HMRC would like taxpayers to believe. This is because a loan is repayable, so it does not ‘belong’ to the recipient.
Let’s take the entirely fictional example of Twit Ltd, whose director and principal shareholder is Melon Tusk. If Twit Ltd makes annual profits (before salaries) up to £1m, and Melon takes this as salary, then Melon will lose roughly half of that profit in income tax and National Insurance contributions (NICs):
The tax take worsens as company profits and salaries increase, since the very highest overall effective marginal tax rates now comfortably exceed 50%. In fact, dividends can now actually lose more in tax than taking salary:
Salary will generally reduce a company’s taxable profits, but dividends can be paid to shareholders only once the company has provided for the company’s corporation tax, etc.
Following the recent increases in tax rates, while dividends start off a little cheaper than salary (see Melon’s net income from profits of £300,000), in this very simple example Melon is almost £6,000 better off taking pure salary than taking only dividends. Even so, either route costs a lot in tax, NICs, etc.
But if Twit Ltd is comfortably making substantial profits every year, why not simply lend the money to Melon? That way, the company will likely have to pay 25% corporation tax on its profits, but there will be no expensive income tax or NICs hurdle to get the money into Melon’s hands (or bank account).
In our examples, Melon owns most if not all the shares, so if he decides to keep on borrowing the annual profits left over after 25% corporation tax, he could take £225,000 or £750,000 a year when compared with the above scenarios, which would be much more attractive. It’s his company, so who is going to stop him?
Well, company law will require him as director to look after the company’s interests and assets in broad terms (and you should always check that the company’s Articles of Association permit loans to officers of the company), but the tax regime also has a couple of important constraints.
1. Income tax charge: Taxable cheap or interest-free loans
Tax law sets an employee benefit-in-kind tax charge on the provision of interest-free loans to employees, even using a low rate that is deemed not to be a commercial rate, so it is ‘cheap’. The current official rate is 2.5% per annum, so assuming Twit Ltd charges 0% interest on Melon’s loan:
Note: Melon has no other income sources and takes only a loan from Twit Ltd, so he still has his income tax personal allowance to set against the notional loan interest benefit-in-kind.
However, we should expect HMRC’s official interest rate to increase, broadly following the significant and repeated rises in bank lending rates over the last year or so. The corresponding tax cost will likely also increase a little as a result.
2. Section 455 tax on loans to participators
‘Close’ companies (basically, small family companies) have to pay a deposit of 33.75% tax on a temporary basis, of whatever amount they lend to ‘participators’ – usually, shareholders:
Melon actually has more money available to him immediately under this DLA route than via salary or dividend, and the section 455 tax should eventually be repaid by HMRC as and when the loan is repaid.
Options in the longer term
Having established that Melon cannot just extract all his company’s post-corporation tax profits as a long-term loan without consequence, and that Twit Ltd will eventually want its section 455 tax back – and the loans – what are Melon’s options?
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Use income from the company itself – the most common scenario is for the company to pay additional salary, or a dividend, to the credit of the director-shareholder’s DLA to bring it back into credit (or at least reduce it). In such cases, the initial DLA loan may be considered to have helped cash flow by postponing a large tax charge that would have arisen much earlier if the salary or dividend had been paid instead of the original loan being advanced.
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Repay the loan from other sources – in our case, Melon has no other income sources; but many owner-managers will have more than one company or more than one business; smaller loans could be paid off from bonuses, salaries or profits from other sources.
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Formally release or ‘forgive’ the loan – this may, in some cases, be the neatest approach, so long as it is arranged correctly. The company will draw up a formal ‘deed of release’ in favour of the indebted director-shareholder – who will be taxed as if they had received a dividend equivalent to the amount forgiven at the date of the release. So, it would also act to postpone the personal tax cost, but it can be more straightforward to arrange to release one shareholder’s DLA debt than to arrange a dividend for all shareholders and then deal with waivers for the other shareholders who do not have overdrawn DLAs and do not want the extra dividend income.
Melon can use a combination of these measures, and the company may reclaim section 455 tax back in proportion as the loan is paid off.
Finally, note that if Melon decides that he wants to liquidate the company, the liquidator may want to see his loans repaid to the company before allowing the liquidation to proceed.
Conclusion
Company loans or DLAs can have a relatively low annual tax cost and be very useful if the company has the money available and the director-shareholder needs substantial funds for private or other uses. Where the loan may be outstanding for some time, the company will ideally also have the spare money to fund the section 455 tax obligation. But the loans must be managed carefully, as the regime for section 455 tax and loan repayments can become quite involved. Even when section 455 tax does have to be paid, the shareholder can still end up with more initial funds through a loan than through simple salary or dividends. But you cannot plan to write off or release a loan from day one (it would not be a loan if you did), and the section 455 tax must be monitored carefully and reclaimed at the right time – it can be forfeited if left too late.
