NICs On Directors’ Loan Accounts

Lee Sharpe looks at another tax (and National Insurance contributions) trap for directors’ loan accounts.

In last month’s article, we looked at the payment of dividends and whether or not they could lose their relative tax-efficiency by being re-categorised by HMRC as salary, so as to be subject to PAYE and National Insurance contributions (NICs). In this article, we shall look at a related issue, which is when director/shareholders make regular use of their loan accounts with the company to finance private living expenses.

Some readers may wonder, what is the difference between a dividend and simply drawing down on the loan account? After all, a dividend entitlement can be drawn down from a director/shareholder’s account in pretty much the same way, practically speaking. 

The simple answer is that it is all in the paperwork. If, at the time of the withdrawal, it has been correctly documented as a dividend, then it is a dividend and taxable accordingly (this is subject to the overarching rule that a company must have sufficient distributable profits to pay out the dividend and, as we saw last month, the potential issue that – in some relatively rare cases – HMRC can reclassify dividends as earnings, solely for tax and National Insurance purposes).

But – and as many practitioners are all too aware – a substantial proportion of director/shareholders will regularly use company funds to finance their private lives, with scant consideration at the time of how the withdrawal(s) might be categorised or taxed. Such withdrawals are commonly referred to as ‘advances’ on the account.

HMRC has the power to classify a withdrawal as earnings for NICs purposes, on the basis that it is a payment made on account of earnings. Given that we are talking about payments the company has made on behalf of a shareholder/director where the shareholder/director himself has not considered how the payment should be categorised, this could be seen as a power bordering on the supernatural. 

The reality is disappointingly mundane; in effect, HMRC looks back at payments that have already been made and says that, at the time they were made, they were in fact advances on account of earnings and should therefore have been subject to NICs. 

This may seem a bit harsh, but, in fact, there is legislation in support of this approach (the Social Security Contributions Regulations, SI 2001/1004, reg 22), which says that a ‘payment made on account of, or by way of, an advance on a sum which would be earnings for those purposes…’ is in itself earnings for NICs purposes and should be subjected to NICs accordingly. 

Alison Always-Late owns her own profitable dressmaking company and has a director’s loan account. For convenience, she has set up direct debits from her company bank account to pay private living expenses such as her mortgage, car loan, and similar. She ‘tops up’ the loan account by declaring an amount of salary to compensate for the withdrawals on an annual basis. She works out the PAYE tax and NICs due and pays them over to HMRC while taking the net salary to credit her loan account with the company.

Let’s say that HMRC opens an enquiry into the company’s tax affairs and ends up reviewing Alison’s loan account movements (which is not uncommon). HMRC concludes that the amounts taken out every month are ‘advances’ on account of the salary that Alison has accounted for some time later in the year. HMRC says that each of the payments made on Alison’s behalf is, in fact, a small amount of salary, and PAYE and NICs should have been accounted for at the time those payments were made, which is the key point of regulation 22.

HMRC can now charge penalties for failure to make RTI returns on those earlier payments, and interest for late payment of PAYE, etc.

Many readers – particularly practitioners – will know more than one ‘Alison’. And many readers will be aware that having an overdrawn loan account should be avoided for other reasons, such as the potential exposure to a benefit-in-kind employee tax charge on an ‘interest-free’ loan, or the possible corporation tax charge on the company under the ‘loans to participators’ regime if the loan is not repaid in time. But the solution is relatively straightforward. 

Peter Perfect is shareholder/director of his own profitable photography business. Peter also pays himself a salary on an annual basis, where the net after-tax income is credited to his loan account with the company; he also makes numerous withdrawals from the loan account over the year. 

But, crucially, he ensures that his loan account is comfortably in credit. He can, therefore, argue that amounts paid on his behalf by the company are not advances against future earnings to be paid, but simply amounts withdrawn from funds that the company already owes him. 

In the first example, HMRC can establish a link between the amounts paid by the company on Alison’s behalf and a later payroll payment to bring her loan account back into credit. In the second example, the company always owes money to Peter and is paying off its debt to Peter, rather than advancing money to him. 

Theoretically, HMRC could still attack Peter’s arrangements if they could make a strong link between regular withdrawals and a later bonus payment or similar. But it is much more difficult where the loan account is comfortably in credit, as HMRC admits in its National Insurance manual at NIM12018:

‘…it could be claimed that regular monthly cash withdrawals are withdrawals on account of earnings. However, the director’s opening credit balance is such that it would be very difficult to prove that the withdrawals are not repayments of loans, without other facts to substantiate the claim.’

It seems fairly settled that dividends can be re-categorised as earnings only in relatively unusual circumstances (as outlined in last month’s article). So, if Alison had repaid her loan account by dividend HMRC would again find it difficult to show that the original advances were on account of future salary or other earnings. Dividends might well prove to be the preferred method of loan account repayment – not least because they are often more tax-efficient overall. But there are reasons why dividends are not always practical, including:

Having warned that payments from a director’s loan account – particularly one that is overdrawn – could potentially be classified as earnings, I have identified a couple of straightforward solutions. 

Ideally, dividends or bonuses will be paid at the beginning of the year (or perhaps at intervals throughout the year), so that the loan account never becomes overdrawn in the first place. Of course, in an ideal world, all companies would have the funds and the time to arrange their dividends and salary payments comfortably before use of the director’s loan account becomes problematic.