Director’s loan account can be very effective tools to reduce UK tax liability that essentially works by tracking the flow of funds between you as an individual investor/director and your company.
If you are owed money by your company, you can use a director’s loan by listing yourself as a creditor, so that you can freely withdraw funds, without incurring income tax or national insurance.
In cases where you owe the company money, you could incur costly tax fees due to avoidance rules—typically a 32.5% tax liability on behalf of the company in addition to tax charges on low interest or interest-free elements.
When the company owes you funds, however, these provisions do not apply—meaning that you can set the loan as interest-free or characterise it as a fully-commercial interest-bearing debt. Regardless of how you choose to charge for the loan’s repayment, you do not incur any tax under this method.
However, it is important to keep in mind that if you choose to set the debt as in interest-bearing loan, the interest payable will be treated independently. This interest payable can be claimed as a tax deduction according to loan relationship provisions (essentially granting you with a corporation tax deduction). Though this tax payable can be claimed as a deduction, you would incur a personal income tax for the amount.
When is a director’s loan appropriate?
A director’s loan is applicable any time that the company owes you a loan repayment or owes you for unpaid company services or contributed assets. For example, if you transfer a vehicle to your company and represent the transaction as a capital contribution or debt, then the company can repay you for the value of the asset tax-free in the future.
So, imagine that the vehicle is valued at £5,000, the company would, in this case, reflect the value of the vehicle as a loan or credit account, or it could list it as a capital credit payable to the shareholder’s account. Instead of extracting funds from the company instantly, you can use a director’s loan to receive repayment in the future for the £5,000 tax-free.
Because of the tax-free benefit, many directors prefer to perform the transaction as a sale rather than a gift—however, there are advantages and disadvantages of each option. On one hand, if you claim the transfer of the asset as a gift, you can qualify for gift relief on your taxes, but there are limitations on gift relief if any reimbursement is made. So when deciding whether to transfer assets as either a gift or a sale, keep in mind that with gifts you cannot receive reimbursement in order to qualify for the tax benefits.
Director’s loans most often arise when a company incorporates—meaning that the business is transferred from the individual to the company. When a company incorporates, the director has the ability to sell the business at market value—with an incurred capital gains tax of 10% or 20% for the transfer, depending on the director’s income and whether they qualified for Entrepreneurs Relief. The proceeds from the transfer could be left outstanding if needed, and the shareholders/directors could withdraw funds from the company tax-free.
Under this structure, company shareholders/directors would incur a capital gains tax of 10% (with Entrepreneurs Relief), but they would save up to 45% on income tax. In order to avoid capital gains tax liability, directors could choose to gift the business instead of selling it, but in this case, there would be no directors loan established. Some company owners decide to do a little bit of both, by gifting part of their business and selling the rest at market value.
There is also the annual exemption that could be utilised for tax mitigation. For example, a £100,000 asset with a £20,000 gain could be jointly invested by a married couple and then transferred to the company. In this case, the £20,000 gain would be excused by the annual capital gains tax exemption and the full value of the asset (£100,000) could be extracted without tax liability.
Therefore any time that you transfer assets to your company you should consider how this transaction can affect your director’s loan account. If you are also able to extract assets and funds from your company without incurring CGT or other taxes, then you are truly minimising your liability and retaining your wealth.