How to clear a director’s loan account

The usual problem

If your company is controlled by five or fewer people it is a “close company”. If a director/shareholder of a close company borrows money from it, including an overdrawn loan account, that could create a tax bill for both the director and the company. If any of the debt is still outstanding nine months after the company’s year-end, the company has to pay tax equal to 25% of the debt. The good news is that when (if) the director pays back the loan, the company also gets its tax back. So what’s the problem?

Benefit-in-kind

If the director pays no interest on the money borrowed, or less than that based on the Taxman’s official interest rate (currently 6.25%) the shortfall interest paid is treated as a benefit-in-kind on which tax would be payable. Unlike the tax paid by the company, this will not be refunded if the director repays the debt.

Clearing the debt - usual solution

If the director cannot repay the borrowing, the choices are usually either to pay a bonus or a dividend to the clear the balance.

Trap. The bonus is subject to tax and NI, and after this has been taken off there needs to be enough left to cover the loan. That makes this option expensive.

Example. Assuming a director’s normal salary is £60,000 per year, in order to clear a loan of £20,000, a bonus of £33,900 would be needed. The extra £13,900 is all tax and NI. The company would also have to pay NI on the bonus,which in this example would amount to £4,340, i.e. £33,900 at 12.8%.

Tip. Alternatively, the company could pay a dividend, as the tax cost would be less and there would be no NI payable.

Example. Assuming the same facts as the example above, a dividend of £20,000 would create a personal tax liability for the director of £5,000. That’s a big improvement compared with the bonus but there can be problems with dividends.

Trap. If the company votes a dividend, it will be payable to all shareholders not just the one with the overdrawn loan account. This could create unwanted personal tax charges for the others.

An alternative solution

S.421 of the Taxes Act 1988 says that if a loan of this type is written-off by the company, then it’s treated in the same way as if it were a dividend paid to that director in question. So writing off the loan effectively targets a dividend to the director/shareholder involved.

Another solution

It may be that some directors are in credit with the company. Perhaps, for example, a husband and wife run company where one has an overdrawn loan account and the other is in credit. This situation can offer further tax savings.

Tip. You can reorganise the loan accounts by setting an account in credit against another in deficit. You could then write off the reduced balance. This must be a genuine transaction and not just done to deceive the Taxman, otherwise he could challenge it.