Extracting surplus cash from a company using loans to directors

directors loans

Owners of businesses, who are usually also directors of the company, have a number of ways of distributing surplus cash from that company. This is normally done via salary, bonuses, dividends and share buy backs. Directors might also consider taking a loan from the company they own. What are the advantages and disadvantages of taking cash out of a company in this way?

Form of loan
A director may take a loan from a company. The terms of the loan, including repayment, interest payments and security, can be agreed between the company and the director and must then be approved by the members of the company. The terms could be on arms’ length terms reflecting the type of loan the director might get from a bank or an unconnected lender. Alternatively, the loan could be on more favourable terms to the director, provided the members of the company are comfortable with the risks inherent in such a loan and prepared to approve it.

Tax on a loan to a director
The main tax consequence of granting a loan to a director falls on the company that has made the loan. HMRC requires the company to pay corporation tax on any loan advanced at a rate of 32.5% of the amount. This tax may be recorded as a tax asset by the company since it is repayable by HMRC when the loan is repaid. If the loan is not repaid the tax may not be recovered and the tax paid should be charged to profit when the loan is written off.

In addition, if the loan is made on favourable terms, say, without interest, then the benefit received by the director must be calculated (in this case being the difference between a market rate of interest and the amount of interest actually paid). Any such benefit is subject to income tax on the employee, as a benefit in kind for the employer and the company will be subject to class 1A national insurance on the value of the beneficial loan interest at 13.8%.

Repayment of a loan to a director
If a director wishes to extract cash from a company he or she owns using a loan then all of the directors should be aware of a number of legal issues.

First, the Companies Act 2006 requires that loans to directors must, subject to a limited number of exceptions, be approved by the members (i.e. owners) of the company making the loan. In granting the loan the board should ensure that it is in the interests of the company to advance the loan to a director and that it is not prejudicial to the interests of the creditors of the company to make such a loan. In light of this the board may not wish to recommend shareholder approval of loans that exceed the distributable reserves of a company.

Second, the director receiving the loan should be aware that the loan must be repaid. In the event that the director loses control of the company or it becomes insolvent then the new owners or controllers of the company will probably seek repayment of the loan from the director. If the director does not have sufficient funds to repay the loan in accordance with its terms then the company may be able to bankrupt the defaulting director.

Disclosure of loans to directors
A loan to a director by a company is a loan to a related party. The loan and its terms must be disclosed to the members of the company prior to obtaining their approval for the loan. In addition, the terms of the loan must also be published in the financial statements of the company once the loan has been made.

Why take a director’s loan from a company you own?
There are circumstances where a director might consider taking a loan from a company he or she owns which has surplus cash resources.

For example, if a director considers it likely that in due course he or she may sell the company then the tax effect of taking a loan could be beneficial. In the short term, the tax paid in respect of the loan will amount to 32.5% on the loan advanced plus the prevailing rate of corporation tax (currently 19%) on the profits of the company. This gives an aggregate tax charge of 51.5% if the loan is paid out of profits, instead of, say, a dividend. This is not particularly attractive. Upon a sale of the business, however, the loan could be repaid allowing the corporation tax on the loan at 32.5% to be recovered. In addition, the sale proceeds used to repay the loan would be taxed as a capital gain and not as income. This gives the selling director a more favourable tax treatment than receiving an equivalent amount to the loan as income rather than as an element of the sale proceeds of the company.

The risk in this approach is that the sale does not take place, or worse, the sale proceeds are insufficient to repay the loan. There is also a catastrophic risk that the company becomes insolvent. In this case, not only has the director lost the equity value of the business but also must repay the amount of the loan advanced by the company.

Provided a director is confident in the prospects of the company he or she owns and is considering selling the company in the not too distant future, then extracting some of the surplus cash in a business by way of director’s loan could be more tax efficient than taking this cash out by way of dividend, salary or bonus. However, many directors who own a company may consider that the risks associated with a loan to a director outweigh the potential rewards.

DISCLAIMER: This information is for guidance only, and professional advice should be obtained before acting on any information contained herein. We will not accept any responsibility for loss to any person as a result of action taken or refrained from in consequence of the contents of this publication.

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