Directors Loan Account – is it as tax efficient as it seems?

Have you ever transferred a partnership or a sole trader to a limited company?

Typically, the strategy involves “selling” the trading business to the company and instead of receiving cash, the company credits the proceeds to the director’s loan account (DLA) which basically means the company owes the purchase price to the director as a debt which it can repay as and when cash flow allows (the initial sale has capital gains tax implications so professional advice is required).

When the director receives repayment of the DLA there are no further tax implications.

However, there is one downside to this strategy. Before the incorporation, the sole trader or partner owned an interest in a business, which (provided it was a ‘trading’ business) would probably have qualified for business property relief from inheritance tax.

After the incorporation, a significant proportion of the value of the business is now in the form of the DLA, and a DLA does not qualify for business property relief it is effectively treated as cash in ones IHT estate.

Until the DLA has been repaid, therefore, there is an exposure to inheritance tax at 40%.

Redeemable Preference Shares (Prefs) can provide a solution to this problem.

‘Prefs’ are a particular type of share capital which, unlike ordinary shares in a company, can be repaid by the company as and when the terms of the Prefs indicate.

‘Prefs’ are repayable at face value, regardless of whether the company has increased in value since it was issued or not.

As Prefs are really a debt by another name (significantly, Prefs are shown as creditors in a company balance sheet, not as share capital), repaying them does not alter the proportions in which the company is owned.

Although Prefs are not treated as part of a company’s share capital in its accounts, they are “shares” for the purpose of inheritance tax.

This offer significant IHT planning opportunities for:

• Individuals who have previously incorporated their trading business and now have a positive DLA balance;

• Individuals that are considering incorporating their trading business; and

• Individuals that have a trading company and have loaned monies to the company and have a positive DLA.

If you have any issue’s or queries relating to the above please get in touch.