Directors loan – overdrawn tax treatment

What is an overdrawn directors loan?

Quite simply this is when a director has taken more money from the company than they were entitled to take via salary and/or dividends

Why does an overdrawn directors loan account cause a tax issue?

The amount could be treated as a tax free method of extracting cash from a company. This is why we have a close company loan rate to close a potential tax loop-hole.

What is a close company loan rate?

Let’s start with what is a close company first.

To put it very simply, most companies are close companies. This is because the majority of businesses in the UK are SME’s that are controlled by five or fewer participators – usually shareholders – or by any number of participators if they are also directors. In which case, for tax reasons they are deemed to be close companies. Hence as a Director or Shareholder in an SME, you are likely to be affected by the close company loan rate, especially regarding overdrawn Directors loan.

What does this mean?

Without the close company rules it would be very easy to take tax-free loans rather than taxable remuneration or dividends. However with the close company rules any loans to a ‘participator’ are charged a ‘penalty tax’ based on the amount of the loan outstanding. This is an advanced payment of tax and is repaid when the loan is cleared. However it is an area of tax that is often missed by Directors and comes as a nasty surprise when our industry is slow to point this out.

What is the close company loan rate?

The rate of ‘temporary’ tax charged on a Directors loan (loans to participators in close companies) has been increased from 25% to 32.5%, with the increased rate applying to loans made on or after 6 April 2016.

The 32.5% charge applies only to loans to participators, whether or not they are directors. However, loans to directors can also be taxed as beneficial loans regardless of whether they are participators. You may think that this does not affect you, but it is surprisingly easy for a director’s current account to become overdrawn – which would be treated as a loan.

Remember that any personal expenses which have been paid from the company’s bank account may be charged to your loan account.

How does this affect you, the entrepreneur?

A typical renumeration strategy is to pay a small salary that is below the Nation Insurance Limit and then take monthly our quarterly dividends. This is perfectly acceptable and can be a useful way to reduce your effective rate of tax. However, on production of your end of year accounts if your post tax profit is not sufficient to cover the amount of ‘dividends’ paid then you could end up with an overdrawn Directors loan account. (Please note that Dividends are paid from Profit and Loss account reserves and hence you could make a loss in the year but still have sufficient profits remaining from other years to be able to pay the dividend).

The overdrawn Directors loan account is then considered a loan to a participator and hence is charge tax at 32.5% of the outstanding balance (if not repaid in full by the time your corporation tax is due).

Although it’s a good idea to simply avoid overdrawing your loan account, there might be a situation when you really need a short-term company loan. With careful timing, you can make use of company funds for up to 21 months without having to pay the 32.5% charge. And if a charge is paid, timing is also important when it comes to repayment. Doing this just before the company’s year-end, rather than just after, results in a one year earlier tax repayment. If your spouse or partner is also a director and their loan account is in credit, then that balance could be used to offset your overdrawn account. However, for this to work, the two accounts must effectively be operated jointly.