Chris Thorpe looks at the role played by directors’ loan accounts in owner-managed businesses.
One of the first things that a sole trader looking to incorporate their business must get into their heads is that the money within the new company is not theirs. They can no longer casually extract vast wads of notes from the ATM each Friday evening once a company is in place, as that money belongs to the company.
If the owner (now shareholder or director) wants the money, it will often be declared as a salary or a dividend and taxed accordingly. Pensions and charging a rent for use of premises may be an option, but the most common alternative way of withdrawing funds is to borrow them.
Loans from the company
These borrowed sums may subsequently be written off or left outstanding, and there are income tax consequences for both company and ‘participator’ (i.e. shareholder of a close company). A director will be taxed on loans taken out above £10,000 and the company must pay a corresponding deposit to HM Revenue and Customs (HMRC) under CTA 2010, s 455 of 32.5% of the monies if outstanding more than nine months and one day after the relevant accounting period. This deposit is repayable once the loan itself is repaid.
A loan written off will be taxable on the participator as a dividend – or maybe even as a salary (Class 1 National Insurance contributions and all) if they are also an employee. HMRC has been known to deem a write-off as being a reward for one’s efforts as an employee rather than as a return for a shareholder’s investment. Until 2013, there was little stopping a participator from repaying the loan to reclaim the section 455 deposit (or even avoid paying it in the first place) and then instantly taking out another one, and so on. However, ‘bed and breakfasting’ rules now effectively withhold repayment of section 455 deposits in the event of new loans being taken out and the old ones repaid other than by dividends or salary.
Loans to the company
However, a director’s loan account (DLA) works both ways. Not only can a director be a borrower, but also a lender; a DLA can be in credited as opposed to overdrawn. A common occasion is during the incorporation of a business – a newly formed company will have no cash to give the former sole trader if ‘incorporation relief’ (under TCGA 1992, s 162) is not used; so, instead, a DLA is credited with the value of the business. The company is giving the newly-installed shareholder an IOU, to be repaid upon demand. This can be rather handy for the shareholder; not only is it a large sum of money to be withdrawn from the company tax-free, often for many years hence, but also a company credit can be as good as any capital.
Interest can be charged to the company for that IOU, and possibly at rates higher than the banks – 10%, even 15% would be a reasonable rate when lending to a new, unquoted company with no history. Whilst this interest is obviously chargeable in the hands of the lender (with the company deducting basic rate tax on HMRC’s behalf), each taxpayer has a £5,000 0% savings rate and a personal savings allowance of up to £1,000. Along with the personal allowance, and some careful planning, this could mean that a shareholder extracts interest (and salary) of up to £18,570 free of income tax.
Potential traps
Whilst borrowing money from a company seems easier than declaring a salary or dividend, a director taking out more than £10,000 will result in an income tax charge; writing off any such loan also results in income tax charges for the participator/director and, potentially, in charges for the company. But whilst being a borrower can be precarious, being a lender to a company could be a useful part of tax planning.
