The Private Bills Trap

Lee Sharpe discusses the implications of overdrawn loan accounts for director/shareholders of small companies.

It is very common for directors/shareholders of small companies to use company funds to settle personal liabilities. This article will look at some of the tax aspects of such payments, but specifically from the perspective of director/shareholders.

Directors of small companies – particularly those who have run self-employed businesses prior to incorporation – often do not distinguish between the company’s funds and money that belongs to them personally. There is no real barrier between someone who is self-employed and their business and its assets; but a company is, of course, a separate legal entity and the company’s assets belong only indirectly to the shareholder(s).

Some expenses may be said to form part of the director’s remuneration package. Typical examples might include private health insurance, mobile telephone contracts, or professional fees or subscriptions. Provided the bills are raised against the company, rather than against the director personally, the tax treatment will follow the ‘benefit-in-kind’ rules with which many readers will be familiar; some of those expenses might result in a tax charge, but others (such as a mobile telephone contract available for private use and certain professional memberships) may not – in which case they can be tax-free to the employee and allowable in the company’s expenses. But we are more concerned here with a director’s private bills, which the company is settling on his or her behalf. 

Where the company pays for a director’s personal expenses, and they do not form part of his or her remuneration, they are not really company expenses, so should not be claimed in the company’s accounts for tax purposes. The usual approach is for them to be taken instead against the director/shareholder’s loan account with the company. This running balance could be in credit, for example, if the director has introduced funds to help with the company’s working capital, or it could be ‘overdrawn’ because the director has used more company funds for personal expenses than he has introduced overall. 

While some directors and their companies rigorously avoid running a loan account, it is nevertheless commonplace, and the balance will often fluctuate significantly throughout the accounting year.

Where the net balance is owing to the director, there are few tax implications. It is acceptable for the director/shareholder to charge interest to the company (although HMRC can challenge charges that are not commercially justifiable), and this may be an opportunity to make tax-efficient use of the new savings allowance, which is up to £1,000 for basic rate taxpayers and £500 for higher rate taxpayers (but note that it is fully withdrawn for those exposed to the additional rate). 

The company may, however, have to withhold tax on any interest paid under the ‘CT61 regime’ although this would ultimately be reclaimable by the individual through their own personal self-assessment tax return. 

Where the account is overdrawn because the director owes money to the company, there are a couple of issues for which the company is responsible:

In both cases, HMRC says that loans should be considered separately. It is, therefore, theoretically possible for a director to have made a formal loan of (say) £100,000 to the company, but still be caught by the above charging regimes for a loan from the company of just £20,000. 

In practice, however, director/shareholders tend to operate only one over-arching loan account, on an informal basis, so HMRC will usually allow debits and credits to be netted off. 

The above measures are in place to ensure that directors/shareholders do not just take out ever-increasing loans from their own companies, instead of salaries or dividends that are generally taxed much more heavily. Some readers will be aware that there are some company arrangements which purport to get around these charging regimes, so that directors can enjoy interest-free loans at little or no tax cost and with no intention of ever paying them back. 

HMRC has introduced increasingly harsh measures to combat such ‘disguised remuneration’ schemes (under ITEPA 2003, Part 7A). This regime is complex and Draconian but should not apply to ‘vanilla’ arrangements considered here, for loans which are genuinely repayable.

Generally, where a company settles an ordinary employees’ personal bills, National Insurance contributions (NICs) will also be due under the ‘pecuniary liability’ rules which classify such payments as earnings. The effect is that they become as expensive as ordinary salary. 

With directors operating a loan account, HMRC tends to look for personal bills that are paid out regularly, making the loan account overdrawn, which is then brought back into credit by bonus or salary payment. They will then argue that the personal payments made by the company were effectively ‘an advance’ against the later earnings credited to the loan account, so should have had NICs applied at the time they were made. There are two simple defences:

The tax on loans to participators is meant only to be temporary; the 32.5% is eventually repayable by HMRC once the director’s loan is either repaid or is formally written off. A write-off is treated as a dividend to the director/shareholder for tax purposes because he or she is a shareholder (ITTOIA 2005, s 415 et seq.) 

Actually, paying a dividend would mean having to consider other shareholders, but a loan write-off does not, and a write-off can be deferred so that the director/shareholder has had the use of the money, but the corresponding income tax charge is triggered later than it would have been under a simple dividend (although the above taxable loan benefit would be in point, while the employee owes money to the company). 

Loan write-offs must be approached carefully, however; there is a notorious case where a write-off was formally approved at a directors’ board meeting rather than by the shareholders (who were also the directors); wearing the wrong hat, so to speak, meant that the write-off was deemed to arise from the employment, rather than as a shareholder, resulting in a large and unwelcome NICs charge (Stewart Fraser Limited v Revenue and Customs [2011] UKFTT 46 (TC)).