One of the reasons for doing this was to avoid paying National Insurance and PAYE on the drawings, where directors and accountants understandably seek to minimise tax and improve cash flow by treating drawings as dividends.
HMRC are onto this and would prefer directors’ drawings to be accounted for as salary subject to PAYE, which they now monitor monthly through the Real Time Information (RTI) reporting of payroll payments.
It remains the case that directors may receive loans from their company, provided that it is not in financial difficulty and subject to adherence to the provisions of the company’s articles and the 2006 Companies Act. However, loans above £10,000 must have shareholder approval, and terms agreed and documented by the company’s board.
Changes to the tax regulations
Directors should also be aware of changes to the tax liability rules introduced in March 2013 to deter tax avoidance:
If a director’s loan is not repaid within nine months following the end of the company’s accounting period it is treated as an outstanding loan. This can cause problems for the company because it then becomes liable to a Section 455 tax paid by the company. The director is also subject to income tax as a benefit on interest-free loans. The company, and director on his personal return, must also comply with reporting of all this.
Companies and directors are therefore advised to agree the treatment of loan accounts at the time that the loans are made and note this in a board minute at the time.
Additionally, since April 2016 changes to the rules mean the tax threshold on dividends is £5,000. Above this, directors now have to pay tax at 7.5% if they are basic rate payers and at 32.5% if they are in the higher rate tax band. Also the tax charge on outstanding loans to participators was increased to 32.5% for loans, advances and arrangements made on or after 6 April 2016.
All this may not stop the practice of directors borrowing against expected dividends since the only way HMRC know about a directors’ loan is if it is accounted for as an outstanding director’s loan in the company’s year-end accounts. While there are often directors’ loans at year end, they are normally cleared by declaration of a dividend where the accountants do their job and help companies avoid director loans being a problem.
This practice has been a fairly tax-efficient way for directors and shareholders to draw down money from their company.
However, dividends can only be declared if a company has distributable reserves, essentially retained profits.
The problem comes when the company does not have sufficient distributable reserves. In this case the director loans have to be included in the year-end accounts or in the statement of affairs if the company becomes insolvent.
Liquidators have a duty to recover the directors’ accounts from the directors. In the case of smaller businesses, insolvent companies often have very few assets that can realised so the liquidator is often looking to recover director loans to pay her/his fees.
In view of the personal liability for repaying loans, directors would be well advised to declare dividends on a monthly or at least quarterly basis if they want to avoid being in the position of having to repay a director’s account. If there are not sufficient retained profits, then drawings should be accounted for as salary through the payroll. If cash is tight then withholding payments to HMRC is not the solution. They are tightening the screw and directors should seek help from a turnaround or insolvency professional