What is Bed and Breakfasting?
Directors Loan Account Bed and Breakfasting is a term used to describe a practice where directors repay their overdrawn loan just before the end of the company’s financial year to avoid the Section 455 tax charge, only to withdraw a similar amount shortly after. This tactic was historically used to circumvent the tax implications of overdrawn DLAs.
The Basics of Director’s Loan Accounts
If you have just started up a limited company, the Directors’ Loan Account can be one of the trickiest concepts to get your head around. But I promise you it’s not impossible. It is necessary in understanding how you relate to your company and more importantly, how you get your hands on your profits.
The Directors’ Loan Account is not a real bank account. The company may have a business bank account and you may have a personal bank account, but these are both different from a Directors’ Loan Account.
That said, however the Directors Loan account or DLA as it is often known is a crucial aspect of financial management for many small and medium-sized enterprises (SMEs). A DLA tracks any money that a director borrows from or lends to their company. While they offer flexibility to both Director and company, they also come with specific rules and potential tax implications that directors must navigate carefully.
In Credit: When a director lends money to the company, it is recorded as a credit in the DLA. There are no immediate tax implications for the company. However, the director can charge interest on the loan, which the company can deduct as a business expense, provided the interest rate is commercial and reasonable. This can be beneficial for both the company and the director, as it provides a tax-efficient way to manage funds.
Overdrawn: When a director borrows money from the company, it is recorded as a debit in the DLA. If the loan exceeds £10,000 at any point during the tax year, it is treated as a Benefit in Kind or (BIK), and the director must pay tax on the notional interest. Additionally, the company must report the loan on the director’s P11D form and may have to pay Class 1A National Insurance on the benefit.
Dividends to Directors
When a company pays dividends to directors, it refers to the distribution of profits to individuals who hold positions on the company's board of directors. These dividends are a way to compensate directors for their service and ownership in the company. Directors who also hold shares in the company can receive dividends based on their share ownership.
Dividends are often used as a way of paying back the DLA, however dividends can only be declared on the profit after tax and many people get caught out by this and end up without enough profit left over after tax to fully clear the Directors’ Loan Account with dividends.
Tax Implications of Overdrawn Director’s Loan Accounts
If a director’s loan is overdrawn and is not repaid within nine months of the company’s year-end date, the company must pay what is known as a Section 455 tax charge. This is currently, at the time of writing this blog, 32.5% of the outstanding loan amount. Of course this percentage could change in the future so you should always ensure you check what rate is applicable at the time. This tax is refundable when the loan is eventually repaid, but it can significantly impact the company’s cash flow in the interim. In the past this has lead to what has become known as Director Loan Account bed and breakfasting.
Anti-Avoidance Rules
To combat this practice, HMRC introduced stringent anti-avoidance measures:
30-Day Rule: If a director repays a loan and then takes out a new loan of at least £5,000 within 30 days, the repayment is ignored for tax purposes. This rule ensures that short-term repayments followed by immediate re-borrowing do not avoid the Section 455 tax charge.
Motive Test: For loans over £15,000, if there are arrangements to re-borrow the money at the time of repayment, the repayment is also ignored. This rule targets more substantial loans and ensures that directors cannot simply repay and re-borrow funds to avoid tax charges.
Practical Considerations for Directors
Directors should be mindful of the following when managing their loan accounts:
Record Keeping: Maintain accurate and up-to-date records of all transactions involving the DLA. This includes documenting the purpose of each loan and any repayments made.
Tax Planning: Consider the tax implications of borrowing from the company. It may be more tax-efficient to take a salary or dividends instead of a loan, depending on the circumstances.
Repayment Strategies: Plan repayments carefully to avoid triggering the Section 455 tax charge. If possible, repay loans well before the nine-month deadline to ensure compliance.
Professional Advice: Seek advice from a qualified accountant or tax advisor to navigate the complexities of DLAs and ensure compliance with HMRC regulations.
Conclusion
Director’s Loan Accounts can be a flexible financial tool for directors, but they come with strict regulations to prevent abuse. Understanding these rules, especially the anti-avoidance measures like bed and breakfasting, is essential for compliance and effective financial management. By maintaining accurate records and planning repayments strategically, directors can make the most of their DLAs while staying on the right side of the law.
Further Reading
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