When it's worth clearing a director's loan by dividend
If you’re a contractor who owes your company money you’ll know that it can trigger a tax charge, the rate of which was hiked by a swingeing 30% on April 6th 2016.
Whether this course of action is the most cost-efficient, least taxing option for you is another issue. Before assessing where it’ll work, and where it won’t, let’s first establish some facts.
The 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 9 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 Budget 2016, chancellor George Osborne announced he would increase the rate from 25% to 32.5% (of the amount owed) from April 6th.
Contractors, here’s a top 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. Please note however; this course of action may not be beneficial for you. It is therefore imperative that you take advice before declaring such a dividend. You can first read on to gauge whether it would be beneficial.
Top tax-efficient option
If your debt as a director is less than £5,000 and you 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, as the director, you have 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. But fortunately, 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 cashflow.
Higher rate taxpayer – over £5,000
If you are a director who 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 S455 charge.
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. For example, 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.