FAQ: What is a director’s loan, how does it work and what are the tax implications if I take a director’s loan from my limited company?
A frequently asked question from our clients relating to their limited companies is “what is a director’s loan?” Our clients often ask us about this and wonder whether they may be penalised for withdrawing a director’s loan from their business bank account.
Our blog will help to answer this question and provide detailed advice about what a director’s loan is, who can use one, how you go about withdrawing a director’s loan and the implication of doing so on your finances.
What is a director’s loan?
The Government’s website defines a director’s loan as follows:
“A director's loan is when you (or other close family members) get money from your company that isn’t:
- a salary, dividend or expense repayment
- money you've previously paid into or loaned the company”
Every company has a figurative ‘director’s loan account’ which will remain at 0 until you withdraw a director’s loan. If you take a director’s loan, you will then have what’s called an overdrawn director’s loan account.
Who can take out a director’s loan?
You may require a loan for a number of different reasons, such as financing the purchase of a house or for a major purchase. As a limited company director, you can take out funds from the company. However, any money taken from the business bank account – aka the director’s loan account - not relating to salary, dividends or expense repayments will be classed as a director’s loan and this should be considered before you go about withdrawing funds.
Director’s loans must have approval from the company shareholders, particularly loans of more than £10,000. As contractors are usually the sole director and shareholder of their own company, this is quite simple to do. Director’s loans in general should be recorded and signed off on board minutes. If you wish to withdraw a director’s loan, you should ensure that you leave sufficient funds in your business bank account to cover your limited company’s other liabilities, such as Corporation Tax.
For many limited company contractors like yourself, you will also likely be the sole director and shareholder of your limited company, therefore securing the necessary approval from the shareholder will be simple.
How do you withdraw a director’s loan?
Following on from the point above, permission and express approval is required from the company’s shareholder(s) before a director’s loan can be taken.
Director’s loans are withdrawn when company money is taken from the business bank account without declaring dividends or paying salary. Some contractors may also unknowingly end up with a director’s loan in this way if they try to distribute a dividend when there are not enough profits in the company to declare a dividend.
When to repay your director’s loan
HMRC has strict rules on director’s loans. Before taking out a loan, it is important to note that the loan must be repaid within nine months and one day of the company’s year-end. Failure to repay the loan within this timeframe will result in tax implications at a rate of 32.5% on any outstanding loan amount.
For example, if you borrow £5,000 on 10th May 2016 and your company year-end is on 30th November 2016, you will have until 31st August 2017 to repay the loan. That is just over one year and three months to repay the director’s loan. If you choose to withdraw a director’s loan from your limited company, you will need to ensure that you will be able to repay the loan amount within HMRC’s given time frame.
How to repay your loan
To repay the director’s loan you withdrew from your limited company, simply transfer the money back into the company bank account or credit the director’s loan account – which is a figurative rather than actual account - with a salary or dividend payment.
We also advise that you do not take out a director’s loans immediately after repaying another, as HM Revenue & Customs sees this as a tax avoidance tactic called ‘bed and breakfasting’, and has rules to counteract this. For more details please contact us and we will be happy to advise further.
Implications of taking out a director’s loan
Failing to repay the loan amount by the deadline, which is 9 months and one day from the end of the accounting period in which you borrowed company money, will result in tax implications that you will need to face. Any outstanding loan amount that is not repaid will be subject to a supplementary Corporation Tax charge, known as S455 tax, at a rate of 32.5% for loans taken from 6th April 2016, payable to HMRC.
The tax charge can be reclaimed but only when the full amount has been repaid into the limited company. It is important to note that rules and tax legislation surrounding director’s loans are very complicated and any refund on tax charges can only be claimed nine months after the loan has been repaid. Refunds can be a lengthy process and could take years to meet the eligibility criteria.
You should also consider that if you owe your company £10,000 or more in the form of a director’s loan, it will be classed as a benefit in kind or ‘beneficial loan’ as it is essentially an interest-free loan. As such it would need to be recorded on your company’s P11D, and you will also need to record the cash equivalent value of the director’s loan on your personal tax return, a.k.a your self-assessment. The cash equivalent value of a director’s loan is based on HMRC’s official rate of interest for beneficial, which for the 2017/18 tax year is 2.50%.
You will have to pay income tax and National Insurance on the cash equivalent value of the loan based on this notional interest rate; for example, if you had a loan of £15,000, the cash equivalent of the director’s loan would be £375. A payment of Class1A National Insurance on the loan, at a rate of 13.8% of the cash equivalent value, would be £51.75, and the personal tax liability for a basic rate taxpayer would be 20% of the cash equivalent value, or £75.
You could potentially avoid these tax liabilities by paying the interest on your loan equal to or above HMRC’s rate. Using the previous example of the £15,000 director’s loan, this would mean paying the cash equivalent of £375 in tax.
Is it possible to clear a director’s loan if it cannot be paid back?
Most directors who take out a director’s loan have good intentions to pay it back, however if circumstances arrive such as not being able to find a new contract role, sudden termination of a contract or a personal emergency, then company profits may fall and the director may not be able to pay back the loan.
It is possible for a company to clear an overdrawn director’s loan account, or ‘release’ the loan, by distributing a dividend if there are funds available in the company’s business account. If this action is taken the loan will be deemed a dividend under the Income Tax (Trading and Other Income) Act 2005. HMRC could, however, could seek to collect National Insurance Contributions if it argues the company was in fact providing salary or compensation to the director who received the director’s loan. A company is not able to receive Corporation Tax relief on a cleared director’s loan.
Unexpected circumstances may happen where you may not be able to repay a director’s loan, but due to the tax implications involved it is wise to only withdraw a director’s loan if you really need it or in an emergency.
As you can see, dealing with director’s loans can get very complicated very quickly. Our advice is to speak to one of our expert accountants to understand the implications of taking out a director’s loan. Seeking the advice of a UK contractor accountant will mean you can make a fully informed decision and if you appoint a specialist contractor accountant, they can help you navigate the implications of a director’s loan.
If you are already a client and would like to find out more about a director’s loans, speak to our Personal Tax team on firstname.lastname@example.org.
If you are not yet a client but would like some advice on director’s loans, setting up a contractor business or our limited company accounting services, contact us on 01707 871622 or email email@example.com.
At Churchill Knight & Associates Ltd, we provide contractors with quick, easy and hassle free limited company accounting. We have three different levels of limited company accounting services, so whether you are comfortable with handling some admin yourself or want a completely hands-off, stress-free service, we have options for you.
If you would like to find out more about how our service can help you make the most of your career as a contractor and maximise your take home pay, request a callback below or try our take home pay calculator.