Tony Granger examines what happens on death if an individual has a director’s loan account or a partner/LLP member’s capital account where inheritance tax is concerned.
Both directors’ loan accounts and partners’ capital accounts represent money put into the business by the director or partner. Yet their tax treatment for inheritance tax (IHT) purposes is completely different.
Investing capital into the business by its owner can occur in a number of ways. For example, it can be cash dividends declared but not paid out, thus increasing the director’s loan account with the dividends; or he could have introduced private assets into the business, such as a motor vehicle, with the value of those assets increasing his loan account.
Business owners can invest money into their own businesses, such as by buying shares in a limited company. Furthermore, a director might lend the company money, which is reflected in their director’s loan account. Partners will fund the business through their capital accounts. In these latter cases, directors and partners have loaned money to the business, which is treated as capital.
Directors’ loan accounts in credit
Where the director’s loan account is positive, this is money owed to the director by the company.
Money paid in to the company by way of loan to the company belongs to the director personally. On death, this loan account capital must be accounted for in his estate and could be subject to IHT at the current rate of 40%. Whilst this introduced capital may be used in the business as working capital or to purchase capital items for use in the business, it does not qualify for business property relief (BPR) from IHT.
In effect, the capital is treated as a loan made to the business, and interest may be paid to the director at a commercial rate. This interest would be deductible to the business but taxable in the hands of the director.
Leaving director’s loan account funds in the company could cost the deceased’s estate dearly. For example, a DLA of £250,000 will lose 40% (£100,000) in IHT.
In some cases, it may be possible for a director’s loan account to be capitalised into further shares potentially qualifying for BPR, with the shares passing to heirs free of IHT on death (subject to the BPR conditions being satisfied).
Partnership capital accounts
A partner’s or LLP member’s capital account is an integral part of the business. On the death of an active partner, it is treated as a business asset and generally qualifies for BPR – but the conditions for BPR must be satisfied. No IHT would then be payable on the value of the capital account.
Participating in a partnership or LLP and introducing funds via the capital account could be a tax shelter from IHT. A commercial rate of interest could be earned on the capital. However, the capital could be at risk of loss due to the unlimited liability of partners (unless an LLP).
Repayment of capital account on death
Where capital is employed in a business, on the death of a director, partner or LLP member, repaying the capital owing to the estate may be problematic.
If no cash is available, or credit (e.g. as a keyperson may have died affecting the credit worthiness of the business), the business could have repayment difficulties and the deceased’s estate would still be liable for IHT on the money if a company.
Practical Tip:
Plan carefully to avoid unnecessary IHT costs and future cashflow problems. Use life assurance to cover repayment of capital accounts, if possible.
In a recent case, a sole director and shareholder died leaving money in the company bank account. Over many years, he had injected cash into the business, but there were no records of this. A forensic examination of the bank statements showed a DLA of over £300,000. The executors appointed a family member as a director to close the bank account and pay the account money to the estate – to avoid it becoming ‘bona vacantia’ and reverting to the Crown.
It will always be preferable to ensure that capital is protected from unnecessary taxes – many directors believe that IHT will not affect directors’ loan accounts that are in credit – but generally this is not the case.
