Director’s loans: strategic tool or tax trap for business owners?
Paul Aldridge, CTA STEP, tax partner, Gerald Edelman
Understanding the rules and complexities around director’s loans is essential to sound financial management and effective tax planning, explains Paul Attridge, tax partner at Gerald Edelman
For many of the UK’s 5.7 million small to medium sized businesses, director’s loans have long been a go-to mechanism for accessing company funds when a sudden need for cash arises. Used wisely, they can provide much-needed liquidity without any tax implications – not in the short-term anyway.
But mismanaged, they can have serious tax and financial reputation implications that might undermine the company’s commercial credibility and complicate future growth and exit strategies. Understanding the rules and complexities around director’s loans is essential to sound financial management.
The tax advantages (if managed correctly)
The primary appeal of a director’s loan (DLA) lies in the fact that it facilitates access to funds that are tax-free. Providing the amount is fully repaid within nine months and one day after the end of the company’s accounting period, no tax is payable.
It is easy to see why this might be an attractive option for managing short-term cash flow needs. For example, a director might ‘borrow’ money from the business to cover personal expenses or to bridge a temporary financial gap – all in the knowledge that they can repay the amount within the tax-free window.
Hitting the cash flow hard
Where the DLA becomes potentially problematic is if it remains unpaid beyond the required period. It is at this stage that the company will be required to pay section 455 (S455) tax on the outstanding balance, which is currently 33.75%, this is in addition to corporation tax.
The imposed rate can be reclaimed once the DLA has been repaid but it is punitive – deliberately so. HMRC wants the tax to act as a powerful disincentive for businesses to prevent them from experiencing greater financial stress further down the line.
Indeed, the tax implications are meant to deter directors from using their company as a tax-free personal account. Taking small amounts that can be repaid within the allotted time scale is fine, but larger sums may take longer to pay back and could raise a red flag. Moreover, while small withdrawals may be manageable, large, unstructured loans by contrast infer financial mismanagement on the part of the director.
Balance sheet pitfalls
What many directors overlook is that an outstanding DLA affects the company’s balance sheet which is publicly available and can severely impact the perceived creditworthiness and all-round health of the business. For example, an overdrawn DLA suggests a deficit in the business’s asset base, and this might impact its ability to borrow money from the bank.
Similarly, potential investors and buyers may also be deterred from investing in the business if there remains an unpaid DLA. In our experience, most if not all potential buyers will only complete upon full repayment of the DLA. It also impacts the business’s ability to win new work – especially customers in the public sector.
An overdrawn DLA shows the director(s) as not living within their means. This is a major concern for a business owner with ambitions to sell the company – it suggests a lack of financial restraint and may also be costing the company new contracts.
Advice for business owners
The key is to remember that the company is not a bank. It should not be lending. If necessary, though, loans should be used sparingly, only when necessary, and with a clear understanding of how and when they can be repaid.
Rather than relying on DLAs and the expectation of future profits, business owners should consider prioritising monthly or quarterly dividends instead. Declaring an interim dividend (in addition to an end-of-year dividend) is both transparent and a tax-efficient way to take funds from the business without detriment. It provides business owners with a more sustainable way to draw income from the company.
The need to maintain excellent management accounts cannot be understated. It is the only way to know what profits are available for distribution and ensure that the business remains within its means.
Ultimately, relying on future profits in the current economic climate is ill-advised. Live within your means: if the business is not in profit, avoid drawing any money. Business owners must avoid having a pay-day loan mentality – loans need to be treated as a last resort, especially if it is unlikely they will be repaid within the agreed timeframe.
The best approach is simply better financial management. This won’t come naturally to most business owners, so work with a tax specialist who can provide a better understanding of the company’s current financial position and protect its balance sheet, reputation, attractiveness, and long-term financial health. Not to mention create a greater sense of peace of mind for the director themselves.
