Director loans – avoiding the tax pitfalls

It is common for directors of small companies to have a 'director's loan account'. While you can borrow money from your company, if the loan is not repaid within nine months of the end of the accounting period, the company must pay a 'Section 455' tax charge.

This charge is currently 32.5% of the outstanding loan amount. While the tax is refundable once the loan is repaid, it can create a significant cash flow burden. Furthermore, if the loan is interest-free or at a low rate, it may also trigger a 'benefit in kind' tax charge for the director personally.

How the Section 455 charge works

The Section 455 charge is designed to prevent directors from extracting cash from their companies tax-free by disguising it as a loan rather than taking a salary or dividend. The charge is payable by the company alongside its Corporation Tax liability. When the loan is eventually repaid (or written off), the company can reclaim the Section 455 tax from HMRC, but this process can be slow.

The 'bed and breakfasting' rules

HMRC has strict rules to prevent 'bed and breakfasting'—where a director repays the loan just before the nine-month deadline, only to immediately borrow the money back again shortly afterwards. If a loan of £5,000 or more is repaid and a new loan is taken out within 30 days, the repayment is effectively ignored for Section 455 purposes, and the tax charge will still apply.

Clearing the loan account

The most tax-efficient way to clear an overdrawn director's loan account is usually to declare a dividend or vote a bonus to the director, which is then credited to the loan account rather than paid out in cash. While this triggers Income Tax for the director, it clears the debt to the company and avoids the Section 455 charge. The best approach will depend on the director's marginal tax rate and the company's available distributable reserves.