Tax implications of an overdrawn director’s account

A key fact to get to grips with when you run your own company is that the company is a separate organisation, and the money is not automatically your money. You cannot draw funds from the company bank account, or ask the company to pay for your personal expenses, without some tax and accounting implications.

When you do take money from the company, that payment has to be treated as:

• salary - which must be taxed under PAYE and is subject to national insurance when it is made available to you; or
• dividends - which must be approved by the members and be paid out of the existing profits of the company; or
• a loan - which does not create an immediate tax charge but may do so if the total amount borrowed exceeds £5,000 at any point in the tax year.

The legal rules covering transactions with directors including loans have historically been complex. The new Companies Act 2006 introduces some much needed simplification into this area. In this article we focus on the tax implications of such transactions, of which there are currently no plans to simplify.

A loan may be made up of cash drawings, but also the value of personal expenses that the company has paid for on your behalf. To avoid these expenses being treated as benefits in kind, or as salary payments, and creating high tax and national insurance charges for both you and the company, the company may ‘lend’ you the value through your director’s account in the company’s books, to repay the expense incurred. This loan can quickly lead to an overdrawn director’s account.

When you borrow more than £5,000 there will also be a benefit in kind charge on the basis that you have had an interest-free loan. You will be required to pay tax on the interest you should have paid on the loan, which is calculated at 6.25% per annum. This tax charge applies where you borrow more than £5,000 for any period; whether five months or five years.

A loan made to a director should be cleared within nine months of the company’s year end. If you do not do so the company must pay an extra corporation tax charge equivalent to 25% of the amount of the loan. That tax charge will be set-off against the next corporation tax payment due after you finally repay the loan. The tax charge on the company is in addition to the benefit in kind charge on you personally.

The tax issues are complex and we recommend you contact us for advice before extracting funds from your company.