Over my long experience dealing with small businesses, the most common question I have been asked by the clients is: how much I can take out from the business? And they have every right to ask this question as this is their money and they are running their business to get their salary out in the most tax-efficient way.
For a sole trader or a partnership, the money that remains in the bank account belongs to them and they can withdraw all of it whenever they want. But for a company, this is not the case. So a director of a company needs to look at a balance of a ledger called the Director’s Loan Account (DLA) to get his/her answer to the above question. And we are going to discuss this DLA today as using it incorrectly may prove to be a very costly mistake or using it wisely may turn out to be an effective source of short term finance.
Small businesses with one or two directors cum shareholders need to be very careful with DLA and should keep a close eye on its position. The DLA may consist of the following:
- Any fund provided by the director/directors.
- Any fund drew by them.
- Any expense/tax paid by them on behalf of the business.
- Any expense/tax paid by the business on behalf of them.
- Any interest the business charges them or they charge to the business that remains unpaid.
- Unpaid dividends.
- Unpaid salary.
So, any transactions to and from the business that relates to the directors should come to this account.
If there is a credit balance in this account (i.e. the business owes directors) at the end of the accounting year, the directors can take this excess fund without paying any tax. Also, directors can overdraw up to £10,000 from the business tax-free. But they have to be careful with this threshold as drawing a penny over this threshold will result in paying tax at 32.5% of the total fund overdrawn. This tax is called section 455 tax. However, if any overdrawn amount is paid back within 9 months from the company’s accounting year-end date, no tax is payable. There is a 60-day window before and after the repayment day (30 days before and 30 days after) where they cannot borrow any money from the business, otherwise this will be treated as if they are repaying the later loan and the loan amount at year-end date may remain same and Section 455 tax is still payable. Interest is payable to the company at HMRC’s official rate of interest on the overdrawn amount on a monthly basis. If no interest or less than the official rate is paid, this will be treated as a benefit in kind. The directors have to report this to their self-assessment tax return and appropriate tax and national insurance is payable. However, if the combined loan is less than £10,000 over the whole year, this does not need to be reported to the self-assessment tax return.
If a director borrows from the business and pays section 455 tax, he/she can reclaim this tax in the future once they repay this loan. This claim can be made after 9 months and 1 day from the year-end date in which the repayment is made. Repayment does not always have to be in the form of cash. The company can declare higher dividends and part of this can be set off against this loan rather than paying all of it to the director who is also a shareholder. But the directors need to pay income tax on any dividend declared for them by the company as if they are receiving cash and repaying the loan.
If a company has more than one director, it is always advisable to maintain separate DLAs to keep a clear distinction between their transactions with the business. It is specifically important in the event of closing down the business or one of the directors does not wish to continue or resolve any dispute.
This is an area HMRC has regularly looked at. So take professional advice, especially if you have recently formed your first company to trade.