the number 1 mistake contractors and freelancers make with their finances and how to avoid

The number 1 mistake contractors and freelancers make with their finances and how to avoid

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Posted ByAdmin

As a contractor or freelancer operating as a director through a limited company have you ever thought of borrowing money from your company that's not a salary or a dividend? If you have then you’re classed as having received the benefit of a director's loan. The loan is usually taken out for a short terms with the intention of paying it later. Sometimes company directors use these loans to exploit loopholes in the tax system. Many directors do, of course, repay the loans and pay their tax in full.

These loans are often used to cover a number of personal expenses such as mortgage repayments. However, overdrawing money from the balance available to you as a director can impact your director’s loan account and reveal a flaw in your overall tax strategy.

So how can a loan that generally helps improve cash-flow problems have a negative impact on your tax strategy?

First of all, let’s be clear; the flaw is not in the loan itself.  The intention, the use of the loan could be perfect.  And yet, the absolutely perfect intention of using a perfectly legal resource can have negative consequences.

The flaw comes in the contractor/freelancer’s understanding of a director’s loan account.  Most of them misunderstand the use of the loan and the rules that surround it.  Generally, if a director has a balance available on their director’s loan account, they can merrily set such a payment against their loan account with no tax implications. However, once the available funds are exhausted, the director is in default and therefore a debtor of the company.  This can have two implications:

  1. Corporation tax charge - S455

    A tax charge, currently 25% of the unpaid amount, will arise on the company when the director’s loan account is outstanding for more than 9 months after the end of the company’s accounting period in which the loan arose. You need to include information about this loan on your Company Tax Return. This only applies to ‘close companies’ though - generally speaking a company with less than five shareholders/ directors.

  2. Benefit in Kind

    A benefit in kind arises on overdrawn loan balances of £5,000 or greater (£10,000 or greater from April 2014).  As on overdrawn director’s loan account is effectively an interest-free loan, the benefit is deemed equal to the interest (and calculated by HMRC).

    So as you can see, an overdrawn director’s loan account could result into the number 1 mistake i.e. a S455 charge or a benefit - or both.

So how to correct it quickly?

The key is to keep timely, accurate records and keep the transactions relating to each director separate.  Poor records could result in the misallocation of expenses/payments and ultimately, the right taxes not being paid.

What’s the best solution to deal with an overdrawn loan account?

It may be preferable for the company to declare dividends (profits permitting) if the overdraft could exist for some time.  Whilst there may be personal tax implications for the directors, it’s one of the quickest ways to clear the overdraft.  Also, as dividends don’t attract NI, it is likely to be the cheapest option.

If you are experiencing problems with understanding personal expenses and payments with your company, we would be happy to discuss your circumstances in more detail.

For more information call 020 3507 0022 or email today.