Dividends or Overdrawn Director’s Loan Account?March 21, 2018
Paying yourself from your company is straightforward, isn’t it? You’ve probably been advised the most tax-efficient way to do this is by declaring dividends rather than taking a salary and you just tidy up the paperwork at the year-end. You control the bank account so you just transfer the money. There's nothing major to concern yourself with, right?
If done in the wrong way and from a struggling company, taking funds as dividends rather than through the payroll can lead to directors having significant personal liabilities.
This can (and does) put your home and other assets at risk.
Unfortunately, this is an issue that accountants and business advisers are either forgetting to inform their clients of or which they are simply are not aware of. Either way, it is immensely dangerous as directors can unwittingly end up with huge personal liabilities.
In this article, I will explore the impact of this mistake across a number of business scenarios, including solvent companies, personal service companies, closing solvent companies and insolvent businesses.
Many directors believe that it is more tax-efficient to withdraw funds from a business as dividends and not a salary. So, instead of drawing a regular salary, they pay a regular dividend, which reduces their tax liability.
Even where the business is solvent and its accountant is able to ‘tidy up’ at the year end by declaring dividends, we see too many examples where the director has stated that they took the exact same amount each month.
If you declare the same dividend month in, month out, this looks more like a salary than a dividend with the risk HMRC classify the cash as salary and hit you with an additional tax demand, penalties etc.
Many directors are oblivious to the risk that HMRC will classify these sums as salary, which should go through the payroll.
Whilst it may not happen often, I’m fairly confident that occurrences will increase as HMRC steps up their scrutiny on businesses with a view to increasing tax collection. This increases the risk to businesses owners as HMRC might come knocking at the door one day with a significant historic tax bill.
Personal Service Companies
In the past few years, celebrities and other high-earners have been in the news for using something called a personal service company to reduce their tax liabilities.
If you’ve never heard of a personal service company, here is a quick explanation:
A personal service company is a limited company used by individual contractors, consultants and other self-employed workers to sell their work. There are many benefits to operating as a personal service company, including paying lower taxes
A couple years ago, HMRC began clamping down on these with several well-known television personalities bearing the brunt of the new policies.
The problem exists because HMRC regards many of the individuals behind personal service companies as employees of their client rather than self-employed contractors. As such, HMRC requires them to pay income tax.
This decision, after extensive legal wrangling in the courts, has been applied retroactively, which has left many television personalities and other high-earners with large tax bills spanning several years.
We have spoken to many struggling business owners providing their services through a company for tax reasons who believe they can start up a new personal service company.
However, nobody has advised them they are likely to be caught by the Government's Off-payroll working through an intermediary (IR35) guidelines, which are designed to target ‘disguised employees’.
Business owners utilising personal service companies simply must take advice from their accountant about the potential impact of IR35.
If you continue using a personal services company and are caught months or years down the line, the tax bills can be calamitous.
Solvent Companies – MVLs
When a business owner wishes to retire or exit a certain industry, the most tax-efficient way to extract the value from that business is often to solvently wind it up via a Members Voluntary Liquidation (MVL).
Instead of taking the remaining funds out as salary or dividends and incurring (potentially) in excess of 50% in tax, an MVL can allow the funds to be withdrawn as capital and often be subject to only 10% tax.
However, if part of the assets of that company is a director’s loan account, this can pose a significant problem.
(This problem has arisen only relatively recently and some claim it is a direct result of HMRC’s ever-increasing drive to recover more and more tax.)
If the director’s loan account isn’t repaid to the company either before or during the MVL, the tax benefit of doing an MVL can be completely lost and the amount extracted be subject to full tax at the director’s marginal rate of capital gains or income tax.
In order to access the beneficial tax treatment, the director will have to raise the funds to repay the director’s loan (for it then a short while later be distributed back to them by the liquidator).
It does seem a bit of a circular and costly flow of money but that, I’m afraid, is what is required.
Furthermore, there is the impending problem that if a business owner is unable to raise the funds and decides to put off the MVL until he or she can repay the loan, any outstanding director’s loan account balances will be taxed at the full rate as of 1st April 2019.
Struggling and Insolvent Businesses
The issue here is dividends can only legally be paid out by a solvent company. Where a company is insolvent, these payments to the directors or shareholder are instead a loan that must be repaid by them personally.
In a significant number of the liquidations we have dealt with recently, it’s come as a shock to the business owners that not only have they lost their company but that they also have to repay the “dividends” they have taken.
I can sympathise with these directors as the vast majority received advice from their accountant who didn’t stay regularly involved with the business. However, the buck ultimately stops with the directors.
When directors learn about this rule, they usually say one of three things.
- “What do you mean I can’t just call them dividends?”
- “But that’s what my accountant advised me to do!”
- “Why can’t we just put it through the payroll now?”
Unfortunately, none of these are adequate excuses.
What should a business owner do if they have a director’s loan account balance?
If your business has a director’s loan account balance, you’ve got two options:
- Declare a dividend
- Repay the loan to the company
If you have the funds, declaring a dividend is usually the preferable option. And if you don’t, repaying the loan to the company can work as an alternative.
If both of these two options are not possible, it is highly likely the company is insolvent. In these cases, the directors have usually taken these excessive drawings instead of using the funds to pay its tax liabilities or pay its suppliers.
If your company is insolvent, you should seek appropriate advice quickly from either your accountant or an insolvency practitioner.
At this point, there is not only a risk the company is facing insolvency but also a risk to your personal position, including your home and other assets.
Have You Incorrectly Paid Yourself?
If you have incorrectly paid yourself, it is not the end of the world. With the right advice and support, you can satisfy HMRC's demands and continue trading with the minimum disruption to your business and life.
However, it is still a significant and serious problem and needs to be dealt with carefully.
Unfortunately, not all insolvency practitioners can offer the same quality of care so it's essential you do proper due diligence before selecting someone to work with.
Always remember that the success of a rescue or recovery plan will come down to the skill and experience of the insolvency practitioner and the time they have available. So research providers carefully and select someone as early as possible.
For free initial advice, contact our office today. We will investigate your personal circumstances then advise on how we can offer assistance going forward.