A contractor who is a director and shareholder of their own limited company can have a director’s loan account with their company. What this means is that if the director pays the company’s bills, perhaps in its early weeks of life, then the loan account is in credit.
The director’s loan account, also know as a director’s current account, can also be in credit if the contractor does not draw any or all of their salary and dividend entitlement, which means the contractor’s company owes them money.
And when the contractor takes their money back from the loan account, it is classed by HMRC as a loan repayment and does not attract tax or National Insurance Contributions (NICs) liabilities.
However, when the contractor takes out more cash from the company than has been earned, or has been put in by the contractor in the past, then the director’s loan account goes into debit.
How much can be borrowed?
Technically, an overdrawn loan account where the contractor has taken more cash out of the company than they are owed is illegal under the Company’s Act, although there are no fines payable for breaking this aspect of company law.
This is because in practice this part of the Companies Act was created to protect shareholders from maverick directors taking money out of the business, and the chances of prosecution are rare for a ‘close’ company where the sole director is also the only or majority shareholder, as is the case with most contractors’ limited companies.
However, there can be tax penalties. The maximum a contractor can borrow from their company using a director’s loan before incurring any tax liabilities is £5,000. If the debit balance of the loan, or current account, is in excess of this amount, then the contractor may be liable for tax and NICs.
Technically, an overdrawn loan account where the contractor has taken more cash out of the company than they are owed is illegal under the Company's Act
Directors’ loans can cost contractors money
When a contractor takes the loan account debit balance to more than £5,000, then it is classed as a benefit in kind and has to be reported on the contractor’s P11D.
This can be avoided if the contractor’s company charges interest on the director’s loan, which should be the official HMRC rate or higher. Contractors should remember that interest will increase the amount they owe the company, and their company’s taxable profits will also increase as a result.
Should the contractor not repay the loan by the end of the company’s financial year in which the contractor first took out the loan, then the loan account will be liable for a tax charge of 25% on the balance. This means the contractor’s limited company will have to pay 25% of the outstanding director’s loan amount as extra corporation tax.
If the contractor subsequently repays the entire loan after their company has paid the additional 25% corporation tax, the 25% corporation tax can be reclaimed.
However, if the contractor repays the loan within nine months of the company’s financial year end, so before their company has to pay the 25% surcharge, the company won’t have to pay the tax bill at all. However, it should be noted that in that case the contractor should not then withdraw the full amount again immediately, as HMRC will smell a rat and may well decide the contractor is taking the money as salary rather than a loan; this would mean they would have pay income tax and NICs.
HMRC dislikes overdrawn loan accounts
HMRC will look at a contractor’s director’s loan account and, depending on the pattern of payments to the contractor, may decide that the monies paid are not a loan but are a salary.
This may happen if the contractor is regularly taking cash out of the business without corresponding dividends being declared or if there are insufficient profits to declare a dividend.
If HMRC investigates and spots this pattern, then the taxman may insist that the contractor pays income tax and NICs on the amount the company has paid to the contractor. Contractors are strongly advised not to let their director's loan account overlap into the next financial year otherwise the tax implications can be both complex and costly.
And overdrawn loan accounts are easy for HMRC to identify, as they have to be noted in the corporation tax return.
Taking dividends
If a contractor needs to take money out of their contracting limited company on a regular basis to pay their own personal bills, this need not be a problem as long as the company is profitable.
Profits can be distributed to the contractor as dividends, and technically there is no law to say this could not be daily. However, HMRC may take the view that weekly or monthly dividends are in fact a salary and insist on taxing the contractor accordingly. Contractors are advised to take a quarterly dividend and irregular payments at other intervals.
Contractors who are not sure of their profit position at any given time would be wise to consult their accountant who will be able to help them with management accounts, which can provide regular snapshots of the company’s profitability and help with dividend planning.
Published: Wednesday, December 17, 2008
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