Director’s loan 101

Director’s loan 101 150 150 Purple Lime

Most business owners start their own companies for one reason – they want control over their own life, and what they do with it. There are a number of other reasons of course, but this is the one you will hear from pretty much anyone who has set up by themselves to do what they love. Part of that control is financial freedom. Having the ability to earn as much as you want, and to have access to that money in any way you can. But if you have been around a while, or spent any time talking to an accountant, then you will know that there are several different ways you can take money out of your business, and that each one has their pros and cons.

One of the lesser-known methods of taking money out of your business is called a director’s loan. You may not have heard of it before, or if you have a proactive accountant, they may have told you to take money out of your company as a director’s loan repayment, even if you were not doing so beforehand. As it turns out, there is a very good reason for this method. But first we need to explain what a director’s loan is, how it works, and why you should consider it as an option.

What is a director’s loan?

A director’s loan can come in two forms, and the difference is essentially the direction money travels in. In one instance, you or a close family member will use a director’s loan to extract money out of your company that is not a salary, dividend or any legitimate expense repayment. Instead, it is money your company is loaning you, and you will eventually have to pay it back.

The second option is when a director lends money to the company from their own pocket. This is incredibly common for start-up businesses who need to get set up but do not yet have any clients, and it would be a challenge to find any SME that did not start out this way. Doing this means the director becomes one of the company’s creditors and can withdraw money from the business as a repayment for the money invested when the company is profitable in the future. This avoids things like dividend tax and allows the director to access money that was theirs in the first place.

What is a director’s loan account?

When a director’s loan is issued, your business will need to create a Director’s Loan Account (or DLA) to track and account for it. This account allows you to see what director’s loans have been issued, what money has been lent, and track repayments. Running the account is normally fairly straightforward. If the company is borrowing more from its’ directors than it is lending, then the account is in credit. But if the directors are borrowing more, then the DLA is overdrawn. The account being overdrawn for a long period of time represents a concern for shareholders and stakeholders, which is why managing your DLA properly is so important. A skilled accountant can help you with this and make sure everything runs smoothly.

How much can a director borrow?

Technically, as much or as little as you want! There is no legal limit on how much you can borrow with a director’s loan, but there are a few things you should consider when choosing your loan amount.

The first and most critical is, of course, your own cashflow. The last thing you want to do is borrow more than your company can afford to lend or cause your company significant cash flow issues while you are borrowing the money. Carefully consider how much your business can realistically afford without causing problems.

Next, there is the tax issue. There is a cap to how much you can take as a director’s loan without having to pay tax – at the moment it is up to £10,000. Any amount up to this you can borrow without issue. But anything above it is classed as a ‘benefit in kind’ by HMRC, and so will be liable for tax. This means it has to be reported as income on your self-assessment tax return, and you will have to pay tax on anything over that £10,000 threshold.

Both of these are the reason we recommend getting full shareholder approval before issuing a director’s loan – so that all issues can be discussed, and the best option can be found. It is also worth mentioning that a director can take out multiple loans, but not at once. The first director’s loan must have been repaid for at least 30 days before the same director can take out another.

Are there any drawbacks?

We mentioned earlier that all methods of taking money out of your business come with their pros and cons, and director’s loans are no exception. In this case, the main things to consider are tax and interest.

Firstly, your company must charge interest on a director’s loan – which means you will always end up paying back slightly more than you borrow. It is up to you exactly how much interest you wish to charge, but the general rule is to use the Bank of England base rate as a guide. The main reason for this is that if you charge below this rate for interest, the whole loan could be considered a ‘benefit in kind’ by HMRC, which would lead to more tax being due to bring it up to the Bank of England base rate.

On top of that, you will also need to pay Class 1 National Insurance contributions (13.8%) on the full value of the loan. So, this is another cost you need to bear in mind. And finally, there are costs involved for your business if you repay the loan late – even if you are the only one employed by your business.

How do repayments work?

Sadly, a director’s loan is not something you can take out and just repay as and when. There are some fairly strict rules set out by HMRC about when it has to be paid back. Specifically, a director’s loan must be repaid within nine months and one day of the company’s year-end. This information often impacts the decision about whether to take out the loan, or when the loan should be taken out to maximise the time until repayment.

If the loan is not paid back within this time frame, then it is your company that will suffer in the form of a tax penalty. HMRC will charge 32.5% corporation tax on the remaining balance of the loan as incentive for you to get it paid. Thankfully this tax can be reclaimed from HMRC once the loan is repaid, but it is a difficult and lengthy process, which can cause cashflow problems for your business in the short term.

A director’s loan can be an incredibly beneficial thing for business owners, and if done right can be an efficient method for taking money out of the business. But we would always recommend using a skilled and experienced accountant to help you with it, discuss all of the options and ramifications with you, and guide you through the process of accounting for it and working with HMRC.

At Purple Lime this is something we do quite a lot of, and we are always happy to discuss the possibility of taking out a director’s loan with you. If you would like more information or have any questions about director’s loans that we have not addressed here, we would love to help. Please get in touch by emailing hello@purplelime.uk.com or by calling us on 01249 691360