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Understanding Director Loans

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A Limited Company is a separate legal entity even if it is a one-man company. In a Limited Company, unlike a sole trader firm, there are rules for any financial transactions between you and your company. You can withdraw money from your Limited Company only in the form of a salary, dividend or Director loans. In this article of "Path of Education for New Contractors" we look at Director loans in detail.

Umbrella companies can be of great help to contractors who do not want the hassles associated with running a Limited Company. As part of our series 'Path of Education for New Contractors,' we have covered the basics of umbrella companies in an earlier article. In this article, we look at what are the legal obligations of an umbrella company towards contractors.

Director Loans:

As a Director you are entitled to a monthly salary and, if your company makes a profit, you can also get a dividend. In addition you can claim any business expenses incurred from of your own pocket. If you withdraw money other than those listed above, it will be considered as Directors loans. Before taking a loan from the company, Directors need to secure approval from the shareholders.

Example 1: Let's say you are an IT contractor, and you pay yourself a salary of £10,000. You also claim from your company for any expenses on travelling, beverages, etc. Additionally, you pay yourself a dividend out of the company's profits. Other than these withdrawals, if you withdraw money from your company that won't qualify as a salary, dividend or expense, it will be categorized as Directors loan.

Directors Loan Account:

As a Director, you need to maintain a Directors loan account, which is a record of all the money you have either borrowed from the company or paid to the company. At the end of the year, the balance of the Directors loan account should be included in the balance sheet.

Example 2: As a Director, you have made withdrawals of £7,500 in a financial year, and repaid an amount of £2,500. At the end of the financial year, the remaining £5,000 will be shown on the assets side of the balance sheet as Directors loan.

Taxes:

Depending on the situation, there may be a tax liability on either you or your company on Director's loans. The personal and company tax is determined by the status of the loan, whether the Director owes money to the company or whether the company owes money to the Director.

Tax Scenario I - You have taken a loan from your company:

If you take a Directors loan from your company, either you or your company may have to pay tax. The tax is dependent on how and when do you repay the loan.

Repayment within 9 months and 1 day of the companys financial year:

If you repay the loan during the above period, both you, as an individual, and the company do not have to pay any tax.

However, the company may have to pay 25% of the original loan as corporation tax in two circumstances:

  • You took a loan £5,000, and within 30 days of repaying the first loan (before or after) took another loan of £5,000.

Example 2: Your Companys financial year starts from April 1st and ends on March 30th. You took a loan of £6,000 from your company on May 6th, 2014 and repaid it back by October 1st, 2014 (or less than 9 months and 1 day). In this scenario, neither you nor the company has to pay any tax. But, if you take another loan between 1st September 2014 and October 31st, 2014, your company will have to pay a corporation tax of £1,250 or 25% of £5,000.

  • You took a loan of £15,000 and made a repayment within 2 months. However, at the time of repaying the loan, you made an arrangement or expressed an intention of seeking another loan.

Example 3: Assuming the same financial year as the above example, suppose you took a loan of £15,000 on June 20th, 2014. You repay it back by December 15th, 2014 or less than 9 months of the original loan, but you immediately apply for another loan of £7,000. In such an instance, your company will have to pay a corporation tax of 25% of the original loan, or £1,750 in the above example.

The main idea behind charging corporation tax in these two cases is to prevent misuse of the Directors loan facility. Before this rule, Directors simply borrowed money as loans, repaid it back and then borrowed again.

You don't repay the loan under 9 months and 1 day of the company's financial year:

In such a scenario, Directors do not have to pay any personal income tax, but they need to show the balance amount in the companys tax return. The company will have to pay 25% of the outstanding amount at year-end as corporation tax. Once you make the repayment, this entire corporation tax can be reclaimed back, except any interest incurred.

Example 4: Let's say you took a loan of £8,000 on July 15th, 2013, and you repaid the loan on June 20th, 2014 or more than 9 months and 1 day of the company's financial year ending March 31st, 2014. When filing the company tax return for the year ending 31st March 2014, you should show the amount of £8,000 as outstanding and pay a 25% corporation tax (£2,000) on the outstanding amount. Once you pay back the loan, you can claim this £2,000 back from HMRC.

Loan is not repaid or written off:

If you don't repay the loan, for tax purposes it will be treated as a salary or any other benefit. Your company will have to deduct Class 1 National Insurance on this amount, and you will be liable for income tax on this loan.

Example 4: If you take a loan of £9,000 and don't pay it back, the company will deduct National Insurance on this amount based on your weekly income. Assuming your weekly income is between £770.01 and £805 every week, your company will deduct a National Insurance of £1,242 or 13.8% of £9,000. Additionally let's say your personal income tax is calculated at a higher rate of 40%, you will have to pay a 40% tax on this amount or £3,600. After these deductions, you don't have to repay the loan amount.

Directors loans above £10,000:

As a Director, if you take a loan of more than £10,000 (from year 2014-15) from your company, this will be considered as income. On loans above £10,000, you will have to pay tax according to your personal income tax rate. Also, your company will have to deduct National Insurance on this amount. However, you can avoid the personal income tax on this amount by paying interest to your company at a rate of 3.25% (for 2014-15).

Example 5: Let's say you take a Directors loan of £12,000 for your daughter's tuition fees. The company will deduct National Insurance on this amount at the applicable rate, and you will have to also pay personal income tax. But you can avoid this tax and the National Insurance deduction if you pay 3.25% interest to your company. This method is ideal for short-term loans.

Your company takes a loan from you:

Apart from borrowing from your company, there will be times when you, as a Director, may lend some money to the company. A Limited Company may take a loan from the Director for either meeting short-term cash problems or for investing in a new project. Your company does not have to pay corporation tax on this amount.

But, if you charge interest to your company on a loan provided by you, the interest will be an expense for the company, and it will be an income for you. The company will pay interest after deducting income tax at a basic rate of 20%, and you will have to add this interest income to your personal tax return.

Example 6: If you lend £5,000 to your company at an interest rate of 3.0%. This amount will not be considered as an income for your company so there is no corporation tax payable. The company will pay you interest of £120 (£150 less 20% tax). You will have to show £120 as an income when you file your personal income tax return.

Summary:

As you can see, Directors loans are an easy way of withdrawing money from your Limited Company. But there are many legal loopholes, which need to be taken into account. As a Director, you will have to worry about the implications of such loans on both your companys tax returns and your individual tax returns. If you are interested in hiring an agency, you can check Tempo. Under its Limited Company and Limited Company Gold services for new contractors, Tempo offers complete management of both your Limited Company and your individual tax accounts.

Contractor Calculators

You may also find the following contractor calculators useful for your salary and tax calculations.

If you are looking for accounting support with your new limited company or if you need support setting up your accounts as a contractor, iCalculator recommends Tempo, a solid, dependable company that the team at iCalculator have known and worked with since 2009.

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