Save Tax with Directors Loans
Take money out of your company tax efficiently
THE TOP rate of tax on salaries and bonuses now stands at 51% (including National Insurance). The effective top rate on dividends is now 36.1%. Faced with these heavy charges, many director/shareholders are looking for other ways to take money out of their own companies more tax efficiently. One popular method is to simply borrow from the company instead of taking taxable income.
The basic rules on the taxation of loans made to directors by their own companies:
- The company will be subject to a special Corporation Tax charge, known as ‘Section 419 Tax’, at the rate of 25% on any loans still outstanding nine months after the end of the company accounting period in which the loan was first made. The Section 419 Tax is repaid nine months after the end of the accounting period in which the loan is repaid by the director. It is often possible to make a ‘repayment’ by declaring a matching dividend or a net bonus of the required sum.
- The director will usually be subject to an Income Tax benefit in kind charge based on notional interest at the ‘Official Rate’ (currently 4%) whenever the total sums due to the company exceed £5,000 at any point in a tax year. Any actual payments of interest by the director can be deducted from the charge, but only if made under a formal loan agreement.
- Both tax charges also apply to loans to a director/shareholder’s spouse, civil partner, children, certain other close relatives and certain trusts.
- It may be necessary to get shareholder approval for the loan and it is essential to get the paperwork right. A written memorandum covering the nature of the transaction, the extent and purpose of the loan and the extent of the company’s liability must be made available to the shareholders prior to their approval at a (minuted) meeting or by written resolution.
In a previous article on the subject, we showed you an easy way to make some small savings using a tax-free loan from your company of £5,000 for 21 months; £10,000 for a couple who are both directors of the company. But there’s a lot more that we can do with loans to directors than that!
Larger Short-Term Loans
For larger loans, the benefit-in-kind charge may give rise to total tax costs of up to 62.8% (Income Tax at 50% plus employer’s National Insurance at 12.8%), but these can easily be avoided by paying interest to the company at the ‘Official Rate’ (under a formal agreement).
This could be very useful when the director only needs to borrow the funds for a short period or needs an exceptional amount of cash one year.
Robin runs a small trading company called Sherwood Limited with a 31st March accounting date. Robin lives fairly modestly and takes no more than the maximum tax-free salary and dividend out of his company each year. For 2010/11, these amount to £5,715 and £34,344 respectively: totalling just over £40,000.
Robin has always promised his daughter Marion the ‘wedding of her dreams’ but is somewhat taken aback when she meets Will and announces three weeks later that she wants to get married in June.
Robin has already taken, and spent, his maximum tax free sums for 2010/11 and now he suddenly finds he needs an extra £30,000. To take this as a dividend will cost £7,500 in Income Tax. Instead of this, however, Robin simply borrows the money from the company.
Later, Robin uses his tax-free dividends for 2011/12 to repay the loan between 6th April and 31st December 2011; thus ensuring that there is no Section 419 Tax to pay.
He also avoids the benefit in kind charge by paying interest to the company at the ‘Official Rate’. The company does have a little Corporation Tax to pay on this interest, but no more than £400 at most: that’s still a pretty big saving compared to £7,500 and provides some comfort to Robin when Marion and Will split up a few months later!
In essence, what Robin did was to use his 2011/12 basic rate band in advance by borrowing money from the company this year and using tax-free dividends to repay it next year. You don’t need a family wedding to use this simple method which would enable many director/shareholders to take up to an extra £40,000 out of their company this year with a minimal tax cost of around just 1% (Corporation Tax on interest at the ‘Official Rate’).
If a company continues to lend money to a director/shareholder beyond nine months after the end of the accounting period in which the loan is first made, there will be an additional 25% tax charge: the Section 419 Tax. This is a more expensive option than a tax-free dividend, so long-term loans should generally be avoided where the director/shareholder is a basic rate taxpayer.
For a higher rate taxpayer, the effective rate of tax on a dividend is also 25%. But it’s not the same!
If a higher rate director/shareholder needs a sum of £50,000, they will need to take £66,667 out of their company so that, after paying tax of £16,667, they are left with the required net sum. If they borrow £50,000, the Section 419 Tax will be £12,500. That’s a saving of £4,167, or around 8.3%.
As usual, the benefit in kind charge can be avoided by paying interest at the ‘Official Rate’. As we have seen, this currently leads to an additional annual cost of just 0.84% for a small company with profits not exceeding £300,000. This means that it would take almost ten years before the saving described above is eliminated!
Furthermore, loans invested in a qualifying business and loans not exceeding £5,000 are exempt from the benefit-in-kind charge. In these cases, there is no need to pay any interest: the loan could be left outstanding indefinitely and still be cheaper than a dividend!
Words of Warning
As we have seen, there are savings to be made for any higher rate director/shareholder by using a loan instead of a dividend: even when Section 419 Tax is payable. There are two possible drawbacks to this strategy, however.
Firstly, the ‘Official Rate’ is exceptionally low at the moment and is likely to increase in the future. If, for example, it returns to its pre-March 2009 rate of 6.25% then the annual Corporation Tax cost where a small company is receiving interest at the ‘Official Rate’ may increase to around 1.4%.
Secondly, unless the funds are required for a specific purpose over a predetermined period, there is the problem of how to repay the loan. If the director/shareholder remains a higher rate taxpayer with no other source of funds, this may mean taking a dividend and paying that same Income Tax bill of £16,667 which they avoided in the first place.
The £12,500 of Section 419 Tax would be recovered but all the extra Corporation Tax paid on the director’s interest payments in the meantime would be lost. Ultimately, the company could end up having effectively paid around £700 a year to borrow a mere £4,167. That’s an effective annual cost of almost 17% - as bad as a credit card!
Hence, in the long run, this strategy is generally only worthwhile where the director has other means to repay the loan and is not totally reliant on the company.
Avoiding ‘Super Tax’
Loans become a lot more attractive when the director has income over £150,000 and faces tax at an effective rate of 36.1% on dividends.
In this situation, it will take a dividend of £78,261 to leave the director with a net sum of £50,000 after paying tax of £28,261. Taking a loan instead would therefore produce an initial saving of £15,761.
Even if the ‘Official Rate’ does increase to 6.25%, it will still take over 20 years before this saving is eliminated (where the company is paying Corporation Tax at the small companies rate). That’s plenty of time to wait for a year when the ‘super tax’ rate doesn’t apply: either because the director/shareholder’s income has dropped, or because a future Government has abolished it. Either way, as soon as the director/shareholder is safe from the ‘super tax’, they can pay themselves a dividend to clear the loan at a much lower tax cost
A loan could also be used as a means to avoid having income falling into the highest marginal rate tax bracket between £100,000 and £112,950.
For example, a director with other income of £100,000 this year could suffer an additional Income Tax cost of up to £4,861 on a dividend of £10,000, leaving them with a net sum of just £5,139. Alternatively, the director would often be able to borrow £5,000 for a year tax-free. In many cases, it will then be possible to repay the loan next year by taking a dividend of £6,667 with a tax cost of just £1,667, thus producing an overall net saving of over £3,000.
In other cases, the director could again afford to wait until a year when their marginal Income Tax rate is more palatable. Even after taking the Section 419 Tax into account, the savings would generally be considerable.
Minority and Non-Shareholder Directors
Loans not exceeding £15,000 in total made to full-time working directors owning no more than 5% of the shares in the company (including shares held by spouses and other close relatives) are generally exempt from Section 419 Tax.
This provides a useful opportunity to use loans as a tax-efficient alternative to a bonus for minority or non-shareholding directors (as long as they are not married or related to the other director/shareholders). Without any Section 419 Tax, the effective annual tax cost on a loan can currently be kept to just 0.84%. This may rise to around 1.4% in the near future, but that’s still pretty good compared with effective combined rates of Income Tax and National Insurance (employer’s and employee’s) of up to 73.8%!
As with majority shareholders, there remains the problem of how to repay the loan but the potential savings are so large in some cases that it will be possible to wait many years for a more favourable tax rate and still enjoy an overall saving.