Owner-managers of SMEs often find themselves in a position where they owe money to their company. This is colloquially referred to as an overdrawn director’s loan account (DLA). Where the business is a close company and the director is also a “participator” per HMRC, this can have tax consequences.
The situation often arises because they have taken cash out of the business which has not been processed through payroll, because their salary is just below or equal to the personal allowance of £12,570. Understandably, this is not enough to meet their day-to-day requirements.
The overdrawn DLA is typically cleared through a dividend when the accounts are prepared. This is effectively a paper transaction, since the cash has already been extracted from the business by the director – although the dividend must still be properly declared and recorded.
However, what happens when the DLA remains overdrawn after the year end?
In this note, we explain when an overdrawn DLA can trigger a tax charge, how s455 tax works, the main ways to clear the balance, and the benefit-in-kind issues that can arise if the loan remains outstanding.
The first matter to note is a time limit: the loan needs to be repaid within 9 months and 1 day after the end of the relevant accounting period. If that does not happen, then the close company (not the director) must pay s455 tax. This generally applies where the borrower is a participator, such as a shareholder, or an associate of a participator.
The rate of this tax is based on the upper dividend rate of tax, which is 33.75% for loans made in the tax year 25/26. The tax rate increased to 35.75% for loans made in the tax year 26/27.
Here is the good news: If the loan is later repaid, then this s455 tax can be reclaimed from HMRC. The bad news is that it takes a long time: it is also 9 months and 1 day after the end of the accounting period in which the loan was repaid.
It is worth noting that there are anti-avoidance rules that target repaying the loan and then borrowing a similar amount again shortly afterwards (known as “bed and breakfasting”).
There are four common ways to deal with an overdrawn DLA, but each has different tax, cash-flow and company-law consequences.
1. Dividend
As mentioned above, very often the loan is cleared by declaring a dividend. However, this can only be done if the company has sufficient distributable reserves, meaning there are enough cumulative historical profits within the business.
This option would also mean that neither the company nor the director would have to pay National Insurance on these amounts. However, dividends are not deductible by the company for corporation tax purposes.
If there are insufficient reserves, the dividend may amount to an unlawful distribution.
2. Bonus
If there are not enough distributable reserves, the company could pay the director a bonus instead. The bonus, together with the employer’s National Insurance Contributions (NIC) payable on it, would generally be deductible for corporation tax purposes. The bonus must be processed through payroll, and the director will be liable to income tax at income tax rates (not dividend rates), plus employee Class 1 NIC.
3. Loan write-off
Based on the points discussed above, it might be tempting to write off the loan. If the loan is written off, the director is treated as if they had received a dividend, and the amount written off (or waived) is taxed at dividend rates. This is known as a “deemed distribution”. In addition, the director must declare the loan write-off on their self-assessment tax return.
In addition, a loan write-off is not an allowable deduction for corporation tax purposes.
For a director who is also an employee, the amount released or written off will normally be treated as earnings for NIC purposes, giving rise to employee and employer Class 1 NIC, even though the individual’s income-tax charge may be calculated under the dividend-income rules.
4. Just pay the s455 tax and leave the loan outstanding
If neither a bonus nor a dividend is a workable solution, one alternative is for the company simply to pay the tax. This buys the director time to repay the DLA in due course. Remember that the s455 tax is temporary: it can be reclaimed once the DLA is repaid.
5. Other points:
One of the most overlooked aspects of an overdrawn DLA is the benefit-in-kind (BIK) angle: if the DLA exceeds £10,000 at any time and interest on the loan is either (a) nil or (b) below the official HMRC interest rate, the company will need to pay Class 1A NIC on the BIK element of the loan. The director is also subject to income tax on the BIK element (not on the loan itself).
Conclusion
Overdrawn DLAs can be messy and complicated. The tax consequences can vary quite a bit, depending on what actions are taken. Please get in touch if you need advice or support.
Written by Sean Hackemann, founder of Specialist Accounting Solutions. Sean works with owner-managed businesses that need outsourced finance support, management accounts, cash flow forecasting and senior finance input without hiring a full-time finance director.
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