Director’s loan or dividend? Choosing the better option for close companies

What are the tax implications of a director’s loan?

Tax is far from the only consideration, but rightly or wrongly, it often sways the decision. If you face a straight choice between a dividend and a loan, you need to know the participator’s marginal tax rate. Remember that the payment itself may change that rate.

Basic rate taxpayers are the simplest case. For them, a dividend is always preferable to a loan.

For higher and additional rate taxpayers, the position is more complex. A loan can initially be the cheapest option. The s.455 tax rate of 35.75% matches the dividend tax rate for higher rate taxpayers and is lower than the 39.35% rate for additional rate taxpayers. The s.455 tax also falls on the company, whereas dividend tax falls on the participator. Because the company must pay a larger gross dividend to leave the same amount in the participator’s hands, the s.455 tax take is always lower than the equivalent dividend tax take for everyone except non-taxpayers and basic rate taxpayers.

Most participators will also face a benefit in kind (BIK) charge on any loan, based on deemed interest at 3.75%. They pay this through their Self Assessment tax return. The participator and the company should treat this annual Income Tax charge as the price of the lower initial tax.

What other issues should you consider?

If you plan to repay the loan in the short term and get the timing right, there may be no s.455 tax to pay. In that situation, a loan is probably the right course of action.

Alternatively, you may intend to clear the loan when the company’s financial position improves. In that case, the company can eventually reclaim the s.455 tax, and the extra tax paid to clear the loan brings the annual BIK cost to an end. If this is your plan, consider how the loan will affect the company’s accounts and any trading status the company holds.

You should also consider the uncertainty of future financial changes. Tax and interest rates can move during the life of a loan and affect your decisions. They will not affect a dividend, which is final. Rates could move for or against you. Some changes may be within your control, for instance if a change of circumstances is imminent, and others will not.

Governance is another factor. Is the dividend or loan legal in the first place? If not, what needs to happen to make it legal, and what documentation is required? You also need to decide how to deal with unequal or disproportionate interests amongst participators and other stakeholders.

Then there is the risk of insolvency. Whether a company at risk should be making payments to participators at all is a separate question. But while dividends may be repayable within two years, loans will definitely be repayable. That could leave you in an extremely difficult position. Having watched your life’s work and source of income disappear, you could then have to repay a ‘loan’ you spent long ago.

Finally, consider your personal income. Most people need an income to live on, and only a very small number can sustain living off loans indefinitely.

Should I take a loan or a dividend from my company?

The answer depends on your circumstances. If tax is your main concern, the general position is as follows:

• If you do not pay tax or are a basic rate taxpayer, a dividend is usually the better option.
• If you are a higher or additional rate taxpayer, a loan may be the better option.

As always, do not let tax drive the commercial decision. The table below shows some of the key tax figures for loans and dividends. It leaves out much of the wider detail, and these wider issues are often far more important than a narrow comparison of cash flows, tax and interest rates.