Clearing a director’s loan by dividend – a good idea?

Owing your company money can trigger a tax charge for which the Chancellor increased the rate in the 2016 Budget. It can be avoided by paying yourself a dividend to clear the debt, but is this the most cost-efficient option?

S.455 tax

If a director shareholder owes their company money, e.g. where a director’s loan account (DLA) is overdrawn, and it is not repaid within nine months following the end of the accounting period that the debt arose, the company is liable to a tax charge. This is known as a s.455 charge and in the 2016 Budget the Chancellor increased the rate from 25% to 32.5% of the amount owed.

Tip: One way to clear or reduce a director’s debt in the nine-month window is for the company to declare a dividend which is credited against the amount the director owes rather than being paid to them.

Tax-efficient option

If the director’s debt is less than £5,000, and they have no other dividend income, it makes good tax sense for the company to pay one to clear the amount owed. This is because the first £5,000 of dividends received is tax free (charged at 0%) regardless of the rate of tax you’re liable at.

Basic rate taxpayer – over £5,000

If the £5,000 zero rate has been used but the director has enough basic rate band to cover the remaining dividend, it will only be taxed at 7.5%. This is much lower than the 32.5% s.455 charge. However, unlike the dividend tax the s.455 charge can be reclaimed by the company when the director repays the debt that triggered it. So it’s a trade off between a low permanent tax bill and a temporary, but much greater, loss of cash flow.

Example: Clare is the sole director and shareholder of Acom Ltd. It prepares accounts to 30 September each year. At 30 September 2016 Clare has an overdrawn balance on her DLA of £18,000. Her only income is a salary from Acom of £22,000 per year. To avoid a s.455 charge she must repay the loan before 1 July 2017. On 1 June 2017 Acom declares a dividend of £18,000 which is used to clear Clare’s loan account meaning no s.455 tax is due. Because Clare is a basic rate taxpayer and has no other dividend income, the first £5,000 is tax free and the remaining £13,000 is taxed at 7.5%, resulting in a tax bill of £975, which isn’t payable until 31 January 2018. Had her DLA loan been left overdrawn, Acom’s s.455 charge would have been £5,850 payable on 1 July 2017.

Higher rate taxpayer – over £5,000

If a director is a higher or additional rate taxpayer, a dividend above £5,000 is taxed at 32.5% and 38.1% respectively, This will almost certainly make paying a dividend a less financially attractive option compared with paying the s.455charge.

Dividend planning

Bearing in mind the opposing strategies for clearing DLAs for directors liable to tax at the basic rate compared with those who pay the higher or additional rate, the timing of dividends can be significant.

If there’s a possibility that a higher/additional rate paying director’s income can be manipulated to fall into the basic rate only, say by deferring a bonus, it would then be possible to clear the DLA cost efficiently using a dividend.

If the debt is less than £5,000 and you have little other dividend income, or you’re only liable to basic rate tax, paying a dividend from your company to clear the debt is a good option. However, where you’re a higher or additional rate taxpayer it’s more cost efficient for the company to pay the tax charge on the debt.