What is a Director’s loan?
Got your own Limited Company, heard everyone talking about Director’s loans, but never quite got your head around the concept? Read on my friend….
A Director’s loan is effectively a ‘bucket’ that sits on your Company’s balance sheet. The bucket includes all of the transactions between you (as the Director) and the Company, both in and out.
For example, if you paid £100 from your personal account to buy some Company equipment then your Company owes you £100. That’s a Director’s loan. In this case it’s a Company liability because the company owes the money… to you.
It can go the other way too. Let’s say you’ve received a big payment from a customer and you want some cash to go to the Cotswolds for the weekend. You take out £1,000. Now, you owe the company £900 (£1,000 – £100 for the company equipment you bought). This time, it’s a debtor for the company. Because you as the Director owe the money to the Company (hopefully it was a good weekend!)
But wait, I own the Company! How come it’s not dividends when I take cash out?
Dividends require a dividend voucher to be signed by a Director. Oh, and a board resolution if it’s a final dividend. This is something your accountant should advise you on and prepare, because you’ll want to time it best for tax purposes.
So, simply taking cash out of the company doesn’t necessitate a dividend – remember that one.
So how do I not owe the company anymore?
This is where dividends (& salary) do come in. As a Director, we can distribute you the right mix of dividends and salary in order to keep your loan account from becoming overdrawn. Overdrawn happens when you owe the company money. It’s important to get the mix right between salary and dividends here – to minimise the tax you’ll pay personally.
When a dividend is formalised we’ll charge it to your Director’s loan account. Let’s say you’ve got enough profits to distribute a £2,000 dividend now (nice!). We’ll declare a dividend for £2,000. And now, you’re company owes you £1,100 (+100 -1,000 +2,000). Congratulations – you can take more money out!
Is that it?
Those are the mechanics of how the Director’s Loan account works, yes. It can be applied to other items as well. For instance, home office working claims. Let’s say you charge your business £500 a month for use of your home as an office. The expense gets posted in your company’s profit and loss. But the Company doesn’t pay the money, you did. That £500 is owed to you by the Company – that gets recorded in your Director’s Loan account too.
At the end of the year we take all of the ins – expenses paid personally, monthly salary, home office claims, cash transfers into the company. And deduct all of the outs – generally just ‘cash drawings*’ or where you’ve paid for something personal related using the Company bank card.
The balance is either what you owe the Company (an asset in the company) or what the Company owes you (a liability in the company).
*Remember – taking cash out of the business doesn’t equate to a dividend. So, we refer to it as cash drawings when you take out money.
What happens if I owe my Company money?
Let’s say, based on the cash drawings, home office claims, and salary taken that you owe the company £15,000 at your Company year end.
We’ll put your accounts together, work out you’ve made a £20,000 profit after tax (lets say) – and, distribute you a dividend of £15,000. You’ve already taken the cash drawings during the year to get to the £15,000 position. So all the dividend is doing is clearing your Director’s loan back to nil.
What about the extra £5,000 of profit?
That’s right, you made a £20,000 profit after tax, so you’ve got an extra £5,000 there to play with. What you do with that depends on what’s happening with the business and you personally. You may decide you want to re-invest the profits in the Company (i.e. just do nothing and leave the money in the business). Or, you might want to take an extra dividend personally.
What happens if there’s not enough profit to clear my loan?
You mean, you’ve taken too much cash out of the business! This can happen. It’s called having an overdrawn Director’s loan account. If your loan is overdrawn at your Company’s year end date, you may need to pay tax. You’ll need to file what’s called a S455 return with your Company tax return. There’s good news though – if you pay back the loan in full within 9 months, you won’t have to pay the tax. If you’re not able to pay the loan back within that time then you’ll need to pay a temporary tax (via the S455 submission) to HMRC. The tax rate for this is 32.5% of the outstanding loan balance.
Why is it called a temporary tax?
Because once you’ve paid the loan back in full HMRC will refund the tax back!
Ok, that’s the Company stuff done, what are the personal tax effects?
Personally you may have to declare a ‘benefit in kind’ which would lead to a personal tax bill. Interest needs to be charged by the Company to you. If that interest isn’t charged at the ‘official rate’ (currently 2.5%) then you’ll need to declare a benefit on the difference, and pay a tax. We recommend the company charge tax at the official rate.
Is that it?
Pretty much! HMRC have rules around ‘bed and breakfasting’ so if you think you can pay the loan of and then quickly take the cash out again, think again! HMRC have rules for that.