Tax-Free Loans to Directors
Understanding the benefits and drawbacks
IT USED to be illegal for companies to make loans to directors. Not anymore. Since October 2007, loans of any amount are allowed, providing they are approved by the company’s shareholders. Obviously, for most small companies, this is not a problem because the shareholders and directors are the same people!
Why borrow money from your company? Some directors may do it to cover short-term financial emergencies. Others consider it as an alternative to paying taxable dividends or bonuses.
Loans to directors do have tax consequences, but it is possible to mitigate the damage if you understand the rules.
The Company’s Tax Position
Most private companies are “close companies”. If you are both a director and shareholder of a close company you are known as a “participator”. Some other shareholders are also classed as “participators”.
If a company lends money to a participator the company will have to pay 25% tax on the loan. This is known as the Section 419 charge. Failure to pay it will result in penalties and interest.
However, the 25% tax does NOT have to be paid on any amount repaid within nine months of the company’s financial year end. (The normal due date for the company’s corporation tax.)
So, short-term loans to directors do not attract any corporation tax.
Bill Ltd’s financial year ends on December 31. The company makes a £10,000 loan to Bill, the sole shareholder and director, on April 15, 2009. Bill repays the loan on September 30, 2010. The company will not have to pay the 25% tax and will not have to declare the loan on its tax return.
Even if the 25% tax does end up being paid because the loan is not repaid on time, the tax will be refunded when the loan is repaid. That’s the good news. The bad news is the company will only be repaid nine months after the end of the financial year in which the loan is repaid. So your company could end up waiting up to 21 months to receive its refund!
Loans to Family
The 25% tax applies not just to loans to directors but also loans to your ‘associates’. These include your spouse, parents, children or grandchildren (of any age), brothers and sisters, business partners and certain trusts.
The tax does NOT apply, however, if the loan is made to your in-laws. For example, your company will not be taxed if the loan is to your son-in-law, unless he, or the daughter he is married to, is also a participator.
The 25% tax also does not apply if your company lends money to your uncles, aunts, cousins or friends, unless, of course, they too are shareholder/directors.
The charge will apply, however, if the loan, or the benefit of it, is simply passed on to you or one of your ‘associates’.
Interest on the Loan
The company pays corporation tax on any interest paid to it by the director.
Where you have to be careful is if the interest charged on the loan is less than the “Official Rate” (4.75% from March 16, 2009).
A director who pays interest at a lower rate will be treated as having received a benefit in kind and income tax of up to 40% will be payable. The company will also have to pay Class 1A national insurance at 12.8%.
The benefit in kind is reduced by any interest paid to the company, although a formal obligation to pay is required. So if you pay 2% interest, the benefit in kind will be 2.75% (4.75% less 2%).
Paying interest at the official rate is usually the best course of action. Most companies pay tax on this income at around 21% instead of a total income tax and national insurance cost of up to 52.8%.
Even if you take this interest back out as a dividend, the total tax cost will be no more than 46%, which is still better than 52.8%!
How to Escape the Benefit in Kind Rules
Some loans are exempt from benefit in kind charges, which means your company can make a zero-interest loan with no adverse tax consequences:
Loans for Business. There is generally no benefit in kind charge if the money is used to invest in another company you own. This includes most property investment companies, so it would be possible to borrow money from one company and use it to reduce the mortgage debt in a property investment company (watch out for the 25% Section 419 tax though). There is also no benefit in kind charge if the loan is to a partnership carrying on a trade or profession.
The £5,000 Exemption. Where the total balance outstanding on all other loans made to a director is £5,000 or less throughout the tax year, there is no benefit in kind. Even if you just take the money and stick it in the bank, this provides an opportunity to save some tax and earn more interest. Company savings accounts currently pay paltry interest – often no more than 0.1%, compared with up to 3.5% payable on individual accounts.
Let’s say Jack and Jill, both directors of Jack and Jill Ltd, take loans of £5,000 each at the beginning of the company’s financial year in April. They stick the money in ISAs (£3,600 each before April 5 and the rest after), earning 3.5% tax free. They repay the loans 21 months later, just in time to prevent the company paying the 25% tax. In total, they have earned £600 tax free, compared with the £20 of taxable interest the company would have earned.
Who Does Not Escape the Benefit in Kind Rules?
As we know, loans to family members (except in-laws) trigger the 25% tax on the company. You also have to pay tax on the benefit-in-kind for loans to a relative where the interest charged is less than the official rate.
The definition of relatives here is much wider and includes virtually all your family AND their spouses, so a zero-interest loan to your son-in-law would result in YOU paying tax on a benefit in kind.
There is no benefit in kind charge on any loan you make to your friends, uncles, aunts or cousins unless, again, the benefit of the loan passes back to you or a closer relative.
Loans Written Off
If your company has paid the 25% charge and then writes off the loan, the loan will be treated as a dividend. The company gets its repayment as usual, but you will be subject to income tax on this deemed dividend. For a higher-rate taxpayer, this comes to the same amount.
This could be useful if the company doesn’t have enough profits to pay a dividend – it can make a loan instead, then waive the loan and have it treated as a dividend instead of salary.
However, it could be dangerous to do this. HM Revenue and Customs also has the power to tax loan waivers as a benefit in kind and may do this where the loan was clearly just a device to avoid income tax and national insurance.
Where Section 419 tax has not been paid, you run the risk of having the cancelled loan taxed as salary. To avoid this risk, it is better to declare a matching dividend to effectively repay the loan instead.Finally, as with most tax planning, make sure you do the necessary paperwork. There should be a written memo outlining the nature of the loan, the extent of the company’s liability and the amount and purpose of the loan. This should be approved at a shareholders meeting or by written resolution.