Withdrawing money from private company profits has tax consequences. Different withdrawal reasons have different tax consequences. It is important to be aware of those reasons and the associated tax consequences.
Common reasons for withdrawing private company profits
Profits tend to be withdrawn from private companies for three main reasons.
- To distribute dividends to owners/shareholders.
Dividends can take two forms. They can either be classified as franked dividends or unfranked dividends and declared as income in the shareholders tax return. Individuals who receive unfranked dividends must pay tax on the entire amount. Franked dividends on the other hand is a more tax effective way of receiving company profits and can be used to reduce the individual shareholders tax liability.
- To pay salaries/wages and associated costs such as payroll tax, the compulsory superannuation guarantee and workers’ compensation insurance.
Once again, individuals are taxed on salaries/wages at their marginal rate. An amount is withheld by the employer under the Pay as You Go (PAYG) system and sent to the Australian Taxation Office (ATO).
- To provide a loan (if this is allowed under the company’s constitution).
A loan is classified as any drawings from a business that are not a profit distribution (i.e. a dividend) or wages. You should be especially aware of the potential tax consequences of providing company loans under Division 7A of the Income Tax Assessment Act. The aim of this provision is to prevent individuals (or associated trusts) from receiving company profits and not paying their marginal rate of tax on these funds.
Potential tax consequences of providing private company loans
Private company loans can result in a shareholder or their associates (which includes family members, companies or trusts) being required to include the amount withdrawn in their tax return unless it is compliant with Division 7A provisions. It is important to note that the recipient/s of the amounts withdrawn are required to treat the entire amount of the loan as an unfranked dividend. This means that if you are in the top marginal tax rate, you could be taxed at 47% on the funds you borrow. It is important to note that the loan will still be owed to the company regardless of the fact that the loan has been declared as an unfranked dividend in the recipient’s tax return.
To comply with Division 7A and avoid the loan being treated as an unfranked dividend for tax purposes, you must do one of the following.
- Fully repay the loan prior to lodgement of the company tax return for the year the loan was made or
- Draw up a formal Division 7A loan agreement or
- Prior to 30 June in the year the loan was made, declare the amount withdrawn as a franked dividend by way of a Directors Resolution.
All of these strategies will help to legally avoid the need to declare the unfranked dividend in the recipient’s tax return.
Division 7A loan agreements
These are formal, written loan agreements that specify:
- minimum yearly repayments (these rates are set by the ATO)
- the interest rate to be charged (these rates are also set by the ATO and reviewed annually).
- the loan term. The maximum allowable loan terms are 25 years for secured loans and 7 years for unsecured loans.
Private company compliance with Division 7A is a common focus area for the ATO.
How we can help
Wilson Pateras can help you to ensure your compliance with the provisions of Division 7A. Our team of Melbourne business accountants and tax advisors provides a full range of services for both small-to medium-sized businesses as well as larger organisations.
Contact us today to discuss how we can help your business.