How Could Settling An Overdrawn Director’s Loan Account In Liquidation Cause Your Personal Tax Bill To Increase?

How could settling an overdrawn director’s loan account in liquidation cause your personal tax bill to increase?

On the face of it, seems incredible, doesn’t it? 

But it is not. It is just likely to be bringing a director’s personal tax affairs into line.

What Is Happening To The Overdrawn Director’s Loan Account? Imagine The Position

Imagine a hypothetical situation. As a Director of a UK limited company, you get out your chequebook after a lengthy negotiation with the Liquidator (whose advice you sought to place the company into say Voluntary Liquidation) and you get to a settlement over your overdrawn director’s loan account. You pay over a sum of money to the company in Liquidation that you consider fair, reasonable and affordable. 

The next thing that happens after handing over your hard earned cash to the Liquidator is you get hit with a heavy personal tax bill. How is this conceivable? 

You just paid the Liquidator a substantial sum; you did not earn income but now your personal taxes have gone up. Let’s unscramble the taxes at work here in this not-unknown situation.

The Released Amount Of The Overdrawn Director’s Loan Account

What has happened is you have done a deal or settled your overdrawn director’s loan account with the Liquidator. Your potentially skilful negotiations may well have reduced the amount you pay compared to the sum you might have been liable to pay. 

As a result, you have been released or forgiven from payment of the full sum potentially you are liable for as far as the company is concerned. However, in so far as HMRC is concerned that is not necessarily the end of the story. Why on earth not?

Why Settling An Overdrawn Director’s Loan Account Not Necessarily The End Of The Matter

The reason it is not necessarily the end of the story for HMRC is because historically you in this hypothetical tale (but not uncommon), drew out of the company sums of money and at the time you would not have been liable to pay personal income tax on the overdrawn director’s loan account balance.

In such a situation the hypothetical company probably should have ended up paying tax under Section 455 of the Corporation Tax Act 2010 but now in view of your settlement with the liquidator, the company is now entitled to reclaim it by virtue of Section 458 of the Corporation Tax Act 2010. 

Notwithstanding that position, the amount you have been released from ever paying back to the company because of your settlement with the Liquidator is a sum that if nothing further were to happen, nobody would pay tax on. As a result, an anti-avoidance provision exists in the form of Section 415 of the Income Tax (Trading and Other Income) Act 2005 which says that income tax is charged on the released or written off amount in the case of a close company.

In effect, this is not so much different from an overdrawn director’s loan account written off. The write-off is treated as a charge to income tax. The only difference here is that you will have handed over money to the Liquidator and if you have not obtained tax advice on the consequences, you might get an unwelcome notification from your accountant when your next personal tax return is due for filing.

When you work out what is or is not affordable for you to repay to the Liquidator make sure that you consider the personal tax consequences and factor this into your cashflow calculations.

The risk of course is that many Directors who have a company that goes into liquidation will no longer necessarily involve their accountant or financial adviser in their dealings with the liquidator. This can perhaps cause matters to get missed. The risk is that if say the accountant is not informed about the settlement with the liquidator and the Director is unaware of the Section 415 income tax implications in respect of the released overdrawn loan account balance, then the personal tax return might be completed with a material oversight and error which could lead to future potential interest and penalties from HMRC. 

Always take professional advice when entering into any material transaction.