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Director’s loan and how this works for UK contractors

Director loan and how this works

Introduction -what is a director’s loan account?

If you are a UK contractor and a director of a limited company, you may at some point have a contractor director’s loan account. If this is so, it could arise if you need to lend money to your UK contracting company because it needs to pay some future bills. As a limited company contractor, when you lend to your business, this will be a loan from director to company. Alternatively, you may look to borrow money from your company in the form of a director loan, if the need arises.

The reason for a loan through your contracting business could emerge due to an array of reasons. If a director borrows from their company, this is a loan to a director. Notably, if either of these scenarios arises, the amount you lend or borrow will be a contractor director’s loan. Therefore, how does a director’s loan work?

Initial thoughts

What to think about first

The total amount of the limited company loan between you and the company will be a director’s loan account. When you are a UK contractor, you can view this as your contractor director’s loan account.

A director’s loan

When you are running a limited company the loan account will show as a balance in your company’s Balance Sheet. In normal circumstances, the loan will be repaid in the future. However, such director loans could be an ongoing issue with a balance owing one way or another. We cover this later in the article.

Initial considerations

Contractor director’s loan account -director loan agreement

In both cases, either a loan from or to the company, is there a need for an official agreement in writing for limited company contractors?

Where you are the sole director of your company, there is no need for a director’s loan agreement in writing. However, if you are part of a company with more than one director, a loan agreement between director and company can be put in place. This is due to the fact that other parties are in your business. 

A director’s loan to company

When you lend money to your company, this is a director loan to company. In the future, the business can repay you. This is once it has the funds available and is in the position to do so. This loan from director to company will form part of your company’s Balance Sheet if you do not repay it by the company year-end.

There is also no time limit for when to repay the loan. Notably, you can agree with your company when it should repay you.

The company can also pay you interest on director’s loan to company. When it does, this is a business expense. If it is decided that the company will pay you interest on the loan from director to company, it is up to the two parties to decide on the interest rate. However, the interest will also become taxable income in a personal tax context for the director. If you are the sole director of your company, there is no benefit to this.

Company loan to director 

From a technical standpoint, under the Companies Act 2006, it is not allowed for companies to make a loan to a director or shareholder. This is unless you obtain the shareholder’s approval first.

However, many UK contractors who run their own company will always borrow money from their companies. Essentially, a company loan to director can arise where you take money from the company that is not either:

  • A salary, dividend or expense repayment.
  • A repayment to the company of a previous loan to the director.

When it comes to how much can a director borrow from the company there is no actual limit. However, you must ensure that you repay this in the future.

A loan to a director is quite a complex area. If you prefer an accountant who has knowledge in subjects such as this, please read how to change your accountant.

The two tax effects for a loan to a director 

HM Revenue & Customs (HMRC) have two potential tax implications which connect with loans to directors.

Contractor director’s loan account -tax effect 1 -P11D item -NI for the company and tax for the employee

Company loan to director

The first tax effect will relate to your personal tax. There is a loan to an employee and in this context, it is a director is an employee. This scenario will only apply where the amount you borrow is more than £10,000 at any time in a tax year.

Such a loan to the director is a benefit in kind, and you must report these on the PAYE year-end form P11D. The employer must work out the `beneficial loan interest’ on any loan. You should also report this on form P11D. In addition, you must also report any benefits in kind on your Self-Assessment tax return each year.

The beneficial loan interest rate

The beneficial loan interest is the interest the borrower has not yet paid the employer. This interest is the taxable benefit in kind. You can use the interest rate that HM Revenue & Customs (HMRC) publish. The current director’s loan interest rate in use is 2.5% and you must also report the loan interest benefit on your Tax Return. Dependent upon your overall personal income, you will pay personal tax on the benefit at either 0%, 20% or 40% or 45%.

Furthermore, the employer will pay Class 1A National Insurance (NI). We will calculate this at a rate of 14.53% in 2022/23 and 13.8% in 2023/24 on the same calculated interest and the Class 1A NI is payable just once per year. It is due by 19 July after the previous 5 April.

As a director, if your business makes a loan to your spouse, HMRC will treat the loan as though it was to you. They have already thought of this one.

The tax-efficient way to deal with a loan to a company director 

There is a more tax-efficient way to deal with a contractor director’s loan rather than declare this interest on form P11D. The method here is a company can charge interest to the director on the loan. When it does this, there is no need to report the loan interest on form P11D. As we mentioned earlier, the current HMRC interest rate is 2.5%, and this interest is a cost to the director. When the director pays interest to the company, it will become income for the company. As a result, this extra income will increase the bottom-line profit which is payable as dividends to the director.

Under the interest scenario, the tax cost is the 19% Corporation Tax (CT) on the interest up to 31 March 2023. However, from 1 April 2023 your company will save CT at either 19% or 25%, depending on whether your company is small or large (see our Corporation Tax guide for details).

When you compare the interest on the loan and P11D methods, there is 14.53% or 13.8% Class 1A NI, which is payable by the company. In addition, there is income tax, that is payable by you as the director and you will pay this either at 0% or more likely 20%, 40% or 45%. Therefore, when there is a loan to a company director, it is much more tax-efficient for your company to charge the director interest.

Contractor director’s loan account -tax effect 2 -Section 455 Tax 

Company loan to shareholder 

The alternative to a loan to a director is a loan to a shareholder. This is effectively a temporary director’s loan tax on the value of the loan.

There is a tax effect when:

  • The company will make a loan to a shareholder (who in this case is also a director) in the financial year; and
  • Where the shareholder (director) will not repay the loan within nine months and one day of the financial year.

In summary:

  • If the director’s loan account is overdrawn (the director will owe the company money) at the company’s year-end, the company may need to pay tax.
  • However, if the entire director’s loan is repaid within nine months and one day of the company’s year-end, the company will not owe any tax.
  • Any part of the director’s loan that you do not repay is subject to Section 455 Tax, which is calculated at 33.75% of the outstanding balance.
  • The S455 Tax rate was 32.5% before 6 April 2022. Before 6 April 2016, the rate was 25%.

Contractor director’s loan account Section 455 Tax and how this works

If your director’s loan account is overdrawn by 30 April 2023, you must repay this by 1 February 2024. If you repay the loan by this date, there will be no tax charge.

There can be further potential tax consequences. This occurs when there is a loan from one of your previous accounting periods which you do not repay by the end of the current year. Where there is a loan due at the end of your last financial year which you do not fully reimburse by the end of the current year and Section 455 tax has not been paid on this previously, there is a Section 455 charge due on that balance now.

As we set out above, the S455 Tax charge is now 33.75% of the appropriate loan amount. Out of interest, the rate of S455 charge is exactly the same as the higher rate tax on dividends. Presumably, the rate is set at this level to sway company directors from considering the option to take a loan for an extended time period. Therefore, many directors who take a loan will attempt to repay this within nine months of their company year-end.

It is important to be aware that Section 455 Tax is refundable to your company. Basically, the tax will come back nine months after the financial year, during which you repay the loan to your company.

When a director does not repay the loan in time, the company will pay Section 455 Tax. Therefore, in between paying the tax and subsequently recovering this from HMRC, the company has tantamount lent the amount of tax to the Government.

Repay the loan

When you are ready to repay the loan, you can either:

  • Repay the money into your company bank account; or
  • Allocate a salary or dividend payment against the loan. i.e., record a salary payment or dividend as taxable income but do not draw the actual cash in relation to this. In turn, this will reduce or clear the loan balance. 

Contractor director’s loan account -avoid a Section 455 tax charge

A company can avoid the Section 455 charge on a company loan to director if the director will repay the outstanding loan balance before the corporation tax due date. This date is nine months and one day after your company’s year-end.

However, there are some anti-avoidance rules in place. Notably, it will help if you take care not to fall foul of these rules. These rules will seek to ensure that any repayments of the loan are genuine repayments, as opposed to transactions which are designed to avoid the Section 455 Tax charge. Such transactions will include when you take out another loan very shortly after you had just repaid it.

The main rule is a 30-day rule. This comes into play within 30 days when the director repays £5,000 or more. However, the director then decides to borrow from the company again (this is known as ` bed and breakfasting’). This rule will render the repayment ineffective, where the director will borrow funds again within 30 days. It also does not matter which comes first, the actual loan repayment or the further loan one takes; the 30-day period will apply equally. This measure will prevent a director from deciding to take out a new loan and use it to repay all or part of the original loan.

Contractor director’s loan account examples 

Let us now look at some contractor examples where there are company loans to directors. 

Example 1

John is a limited company contractor and owes his company £6,000 as of 30 June 2023. He originally decided to borrow all of this in the year to 30 June 2022. John will then repay his loan by 31 December 2023. Therefore, there is no S455 Tax payable.

Example 2 

Zoe is a UK contractor and will owe her company £6,000 as of 30 September 2023. Previously she said she will repay this within nine months of the 2023 year-end. At the next company year-end (30 September 2024), Zoe’s contractor director’s loan account will decrease to £4,000.

In this example, she does not repay the company loan to director as of 30 September 2024. Therefore, Zoe’s company will now need to pay 33.75% (£1,350) of the £4K over to HMRC.

If Zoe will repay the balance of £4K to the company by 30 September 2025, the £1,350 will be refundable to her company on 30 June 2026.

Example 3   

Peter has his own contractor limited company and will owe his business £10,000 as of 31 December 2022. His company has already paid over 33.75% of this (£3,375) as S455 Tax.

The loan will increase to £15,000 by 31 December 2023. Peter anticipates this will decrease to £5,000 by 30 September 2024.

In this scenario, there is no S455 Tax due. Notably, the reason for this is because the £5,000 loan Peter takes in the December 2023 year is repaid within nine months of the year-end.

The outstanding loan balance as of 30 September 2024 is £5,000. Therefore, a further £5,000 of the loan is repaid in connection with the December 2023 year. This £5,000 will not receive S455 Tax relief, as the original £10,000 loan that Section 455 tax was paid on relates to the previous year. Instead, the company needs to wait and see the position as of 31 December 2024. If Peter repays the loan in full or it reduces from the previous balance of £10,000, the appropriate amount of S455 Tax will be refundable by 30 September 2025.

There are also further variations of the above examples, which can leave one mystified. If you have a good contractor accountant to guide you, they can ensure that the tax on director’s loans is reported, paid, and recovered correctly.

Final thoughts 

When you run your own company, there can be a) loan from director to company or b) a loan to a shareholder or director in one of your accounting periods. However, in scenario b) the borrower may be both of these. In this case, both tax consequences can apply.

It is key to take into account the guidelines above with regard to a company loan to director. If you borrow from your company, please aim to repay this within nine months of the company year-end. When you have a contractor director’s loan for an extended period of time, please pay your company interest. When you do this, it is much more tax-efficient when you compare this to declaring interest on form P11D.

If you are still unsure and have a good contractor accountant, they will help you understand and guide you through the above.

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