Income paid via directors loan accounts

In a small to medium sized business, it is often the case that a director is also a shareholder.

What is a director’s loan account

When the business owners and the directors are the same, and the profits of the company are up and down over the year, but expected to end up in profit, rather than take a regular salary, or regularly declare dividends, it is common for director shareholders to take money from the company for living expenses over the course of the year, with the expectation of accounting for them in the accounts at the end of the year and meeting the tax requirements at that time. Monies taken in this way must be recorded in a Director’s Loan Account (DLA) to be properly reconciled at the end of the year.

• it is not illegal to take money from a company by way of a director’s loan account;
• a loan account can also be used by a director to lend money to the company, borrow money from the company that exceeds the amount put in by way of investment, or reclaim money that has previously been put into the company;
• the director’s loan account must, however, form part of the books and records, as this forms part of the company’s balance sheet showing monies in and out of the account;
• depending on how the money is accounted for, tax will need to be paid on these drawings – for more information see Abuse of a director’s loan account.

If a director’s loan account is overdrawn at the end of the year, and is not accounted for, then there is a potential tax liability on this, either for the director, depending on the amount, and/or for the company – see below.

Director’s salary via a director’s loan account

It is common that for practical reasons a small business will not declare dividends more than once or twice a year. Dividends must be declared by the company on profits once corporation tax has been paid by the company.

Directors who are also shareholders often will take their salary as a mix of dividends, and as salary under the PAYE and NIC scheme. The reason behind this is to take income in the most tax efficient way possible.

• if dividends are declared at the end of the year that are equal to a director’s loan account taken by way of income throughout the year by the director, then the dividend payments can be used to repay the director’s loan account, leaving a zero balance;
• this is a method frequently used by director & shareholders to repay their loan accounts and take remuneration.

If however a director’s loan account remains unpaid by way of dividends or PAYE/NIC at the end of the year, it is considered that the director/shareholder will have benefited from remuneration without paying tax on the same – see our pages on disguised remuneration. To counteract this, HMRC imposes a charge on all company director’s loans that remain due at the year-end. Whilst this is not classified as a tax, (as it can be reclaimed if the loan is repaid), it acts as a tax on those who chose to draw their income as director’s loans without repaying them. For more information see our pages on loan charges and transfer of liability.

What happens if the company enters insolvency before a dividend is declared?

If the company is insolvent then it is not possible to declare a dividend to repay a director’s loan account as there will be insufficient profit to allow this to happen.

In this instance, then any liquidator or administrator is likely to request that the director repay the amounts that were paid to them by way of a director’s loan. There is a risk therefore that if a company is in financial difficulties and does not pay a salary to a director through the usual PAYE scheme, but allows the director to take money throughout the year with the intention of declaring a dividend to wipe out the loan at the end of the year, then a director may lose that money and have to repay it back to the company for the benefit of the creditors.

Issues for directors to be aware of

HMRC has enforcement measures in place to ensure that tax is not lost in the event of insolvency or other circumstances where directors loan accounts are outstanding at the end of the year, and therefore are never subject to a tax charge of any kind. As set out above, such loans, if still due at the year-end, will be subject to a charge (disguised remuneration).

As a business owner it is important to be fully aware of all the remuneration methods available in order to maximise tax allowances, and the use of a director’s loan account can be key to this, as can the use of all PAYE / NIC allowances available to salary earners.

It is important however that business owners to keep on top of the changing law in this area. HMRC are finding more ways to prevent what they consider to be tax avoidance, and directors loan accounts are sometimes used illegally in this way. The use of a director’s loan account also brings with it the risk of a director incurring personal liability in the event of insolvency.

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At Francis Wilks & Jones we have many years’ experience in acting for and advising directors and shareholders on the best way to approach remuneration in their company situation, and in advising on legal matters arising in respect of your tax liability, particularly with regard to claims out of insolvency or claims for breaches of a director’s fiduciary duties. Contact one of our expert team today for a free consultation to chat through your issues. Please call any member of our team for your consultation now. Alternatively email us with your enquiry and we will call you back at a time convenient for you.