How Discretionary Trusts Work With Profit First

How Discretionary Trusts Work With Profit First

In this weeks article I wanted to continue the business structuring discussions. To following on from the previous articles that focused on Profit First in Sole Trader and Company structures, this week I’m looking at my favourite business structure option of all…Discretionary Trusts.

While many Australian business owners are somewhat familiar with how a company works they are far less comfortable with Discretionary Trusts (often called Family Trusts). This results in many businesses being run inside companies purely because the business owner doesn’t understand the benefits the trust could offer.

What the heck is a Trust?

Trust law is complex and trust administration should always be left to professionals. Having said that, a very simple example of establishing and operating a Trust is below:

I give my wife (Jaine) $1,000 and ask her to look after it. To invest it in accordance with a list of rules i have written down and to ensure any profits generated go to our daughter (Melody).

We have just set up a very basic Trust. The members of my little family are playing the following roles:

  • Settlor – myself
  • Trustee – Jaine
  • Beneficiary – Melody
  • Trust Property/Asset – $1,000
  • The Trust Deed – My list of ‘rules’

If you currently have a trust you might find a $10 note stapled to the front of the Trust deed. That’s your original Trust asset. Don’t lose it!

Why do I love them so much?

One word…Flexibility! Trusts allow your accountant to get creative at tax time and look for ways to better manage taxable income across your family group. They help to prevent situations in which most of the business income is taxed in the hands of one person. There are limits to what the trust can do and the rules are complex, but your accountant will be across it all.

Profit First and Discretionary Trusts

If you are operating your Australian business through a Trust (or considering it) what should you consider when implementing Profit First?

Trusts and Owners Pay

Unlike a company structure the trust can ‘give’ it’s profits to the business owner(s) without the need to put the payments through the payroll system and treat them as a salary or wage. You can process the business owners as salary employees if you wish, but you don’t have to. Furthermore, people can be beneficiaries of the trust even if they don’t actively work in the business.

As I mentioned earlier this increased flexibility allows your accountant to get creative, but you need to work closely with them through-out the year to ensure the profits are flowing to people who qualify as beneficiaries and in appropriate quantities.

Trusts and Superannuation

The superannuation system is a great ‘forced saving’ mechanism. Funds accumulate in your superannuation fund because the law says that if you are an employee you must have contributions made.

A trust structure allows us to distribute profits without compulsory superannuation contributions. This can be great in cases where you want to pay off personal debt or build investment wealth outside of superannuation but it’s not right for everyone. I always recommend a financial planner is involved in those discussions.

If you’d like to make contributions from your dstributions you can, but you’ll need to set aside the appropriate amounts from your Owner’s pay account and transfer them to your superfund.

If you accumulate the funds outside of superannuation and hold them until the end of the financial year then you can make the choice when you are doing tax planning.

Trusts and the Profit Account

The same principles apply to your quarterly profit from the Profit Account. In a trust we don’t have to put this through as a wage and pay superannuation on it. However, you should consider this part of your total ‘drawings’ from the trust for the year when discussing the topic with your accountant.

In Summary

My message for all business owners who use a Discretionary Trust is this: In my opinion you have the best structure available for Profit First. While the system functions exactly as described in the book in any structure, the trust allows the maximum tax reduction potential for businesses that have outgrown the sole trader option. While they can be complex your accountant or Profit First Professional can guide you through every step.

Further Information

Read our comprehensive review of Profit First here

Join the Facebook group here

Using Profit First with Australian Company Structures

Using Profit First with Australian Company Structures

Following on from the previous article that focused on Profit First in Sole Trader businesses I thought I’d write something similar for those operating through a company structure.

An Australian Proprietary Limited Company is a considerably more complex business structure than a sole trader. As such, there are a few additional considerations that are unique to a company.

I usually like to keep my articles easy to read and, for the most part, free of references to specific tax laws. However, the issues you will run into with a company are founded in quite complex tax legislation, so this article is a bit heavier than usual!

Lets explore the points one by one:

1. Company Structures, Owner’s Pay and Division 7A

Anyone running their business through a company will have discussed Division 7A with their accountant at some point. However, for the benefit of those that are not familiar with this piece of tax legislation lets take a high level look at it.

What is Division 7A

A company is a separate legal entity under Australian law. It earns income, pays expenses and ultimately generates a profit in its own right. The company then pays tax on this profit at a rate specific to companies. Currently, most small companies are paying tax at a rate of 27.5%. This tax rate is usually lower than the owner(s) of the business would pay if all the profit was being taxed in their hands.

Now, back in the 1990’s (and prior) wealthy business owners used to abuse this company tax rate. Their businesses, which were earning 100’s of millions of dollars, would be operated through a private company. By paying tax at the company rate they would save themselves millions of dollars in tax every year.

The company would then use these profits to:

  • Buy houses, luxury cars, large boats and other items. All of which were used by the owner’s of the business/company personally, for free; and
  • Lend millions of dollars to the business owner(s) directly, interest free!

It was an incredible tax loophole while it lasted. However, in the late 90’s Division 7A was introduced to stop company structures being abused for tax savings. Now, if you owe money to your private company or you use company owned assets you must compensate the company for this (eg pay interest) or pay tax on the amounts personally.

Division 7A and Profit First

Why is all of that relevant to Profit First? Due to Division 7A accountants need to work with their clients to plan the movement of cash and profit in and out of private companies.

Businesses using Profit First set aside Owner’s Pay and a portion of their Profit Account specifically for the owner(s) of the business. However, if you just take all this cash out of the company and spend it you may inadvertently spend far more income than your accountant wants to put in your tax return for the year.

This results in a tax problem that we only really has two viable methods to resolve:

  1. Put all the income in your tax return and take the tax hit from the higher margin rates; or
  2. Enter into a loan agreement and pay the money back to the company, with interest.

If you are operating through a company and your business is highly profitable (as all Profit First businesses aim to be!) reach out to your accountant. Ask them what your maximum, after tax salary from the business should be to avoid creating a tax headache at year end. This is something they should be able to work through with you quite easily based on your goals and their plans for your business’ tax work each year.

2. What do we do with capital raised through a share issue

As a company grows there may come a point in time at which a large injection of capital is required to take it to the next level. You could borrow the funds from a bank but that requires security and interest payments.

An alternative is to sell shares to investors, this is called a ‘Share Issue’. The investors purchase partial ownership of the company and, in return, inject working capital into the business.

Share Issues and Profit First

The funds received from the investors are not ordinary income to be split between your normal Profit First accounts. Profit First companies that are planning a Share Issue must open another account specifically for this purpose. The account should be held at Bank 2 and all amounts received from the investors must be transferred to this account directly

In Summary

My message for all business owners who use a company is this: Don’t let the above information freak you out! The Profit First system will work exactly as described in the book. The items discussed here are merely Australian specific issues to keep in mind. Your accountant or Profit First Professional can guide you through all of this. In particular, Division 7A is something your accountant should have already been proactively managing. Even if its in the background without your knowledge.

Further Information

Read our comprehensive review of Profit First here

Join the Facebook group here

Want some professional help getting Profit First running in your Australian business?..We can help

Profit First Australia – FAQ’s – Sole Traders

Profit First Australia – FAQ’s – Sole Traders

I’m often asked about modifying the Profit First system specifically for different types of business structures. It is true that each business structure type, and how the structure is used, will present unique challenges. However, the fundamentals of the Profit First system remain the same.

Here are some common questions I am asked in regard to running Profit First in Australian Sole Trader businesses.

A sole trader is ‘the business’. Do I need an Owner’s Pay account?

For me, the answer is absolutely ‘yes’. While I understand that all of the business’ profits are automatically taxed in your hands anyway, using a Profit First Owner’s Pay account can still be incredibly useful.

The Owner’s Pay account accumulates funds based on your Profit First Percentages. The business owner (you) draws a fixed salary from that account each week, fortnight or month. Assuming the salary level has been set at a level the business can sustain this will mean that in good months the account will accumulate a cash buffer. In your slower months this buffer will pay your salary. This can really help business owners who are constantly stressed about the variable nature of business income. Essentially, we have created a regular, steady personal income for you from a business that may not have regular income itself. For many business owners this is a source of great comfort.

In regard to superannuation, using the owners pay account also allows for owner’s payments to be clearly tracked. Should the sole trader wish to make super contributions they can put aside a percentage of each wage payment.

Please note: as a sole trader you are not legally obligated to make super contributions for yourself. I always recommend you seek professional advice around this. Depending on your age and total income superannuation is not allows the most tax effective way to invest your money.

As a sole trader can my Profit and Owner’s Pay accounts merge into one account?

The Profit and Owner’s Pay accounts play very different roles in the Profit First system. As such my recommendation is always to have two accounts.

  • The owners pay account is responsible for providing you with your regular personal income. Your wage for services provided to the business;
  • The Profit Account accumulates funds which are allocated quarterly to either debt reduction, emergency savings or business owner rewards.

For the system to work properly those funds should be kept separate!

My car is also the business car – which account should pay the expenses?

While this question comes up with all business structures it is far more common with sole traders. It’s an important question to answer because it highlights a point at which business owners can manipulate the numbers to allow Parkinson’s law to continue eating up the business’ cash. If something really should be a business expense but we allocate it to personal just to get our total numbers closer to our Target Allocation Percentages then we are cheating ourselves.

My rule of thumb when it comes to expenses that are shared between the business and yourself personally is to use the ‘predominant use test’. If the expense is predominantly (more than 50%) personal, then you pay for it from the owners pay account. If the expense is predominantly business, then your Operating Expenses account should pay for it.

The Predominant Use Test and Tax

It’s important to note that all we are discussing here is where the cash comes from to pay the bill(s). It has no impact at all on whether your accountant can claim some of the amount as a tax deduction or not. Keep clear records of all expenses which you feel are partially business and partially personal. Give these records to your accountant at the end of the year. In the case of a motor vehicle these records should include your logbook.

In Summary

My message for all Sole Traders is this – treat your business the way you would any other business structure when it comes to Profit First. Set the accounts up the same way everyone else does. Treat the business and yourself as two separate ‘entities’ when it comes to managing cashflow.

If you stick to that approach I guarantee you’ll avoid any of the pitfalls that come with treating your business income account as a personal ATM!

Further Information

Read our comprehensive review of Profit First here

Join the Facebook group here

Profit First and The Tax Reduction Myth

Profit First and The Tax Reduction Myth

It is tax planning season for Australian accountants. This is the period during which you should be meeting with your accountant to estimate your tax liability for this financial year and discuss any possible management strategies.

In the Profit First book Mike touches on his concerns around the advice many accountants give their clients during this process. Given that I completely agree with Mike’s points I thought I’d discuss the topic in more detail.

The core of the issue is the following statement:

 

I want to pay as little tax as possible.

Shouldn’t I run up expenses and buy assets so that I pay less tax?

 

This is one of the most widespread, damaging myths in money management. Find the oldest member of your family that has ever run a business and I can guarantee they either believe this to be true or have been advised to do this by accountants or other business owners.

Running up expenses just to reduce taxes is the same as spending ten dollars just to save three. It’s incredibly damaging to your business cashflow and, in most cases, only manages to waste seven dollars!

Your goal is to run the business as profitably as possible. That is your key to achieving financial freedom. You should work closely with your Profit First Professional to reduce your tax liabilities as much as you can without creating cashflow distress in the business.

Current Tax Planning Myths that perpetuate the problem

 

Myth 1: Buying assets to take advantage of the $30,000 instant asset right-off is good tax planning.

Currently, Australian small business owners can claim an immediate write off for assets with a purchase price of less than $30,000. On the face of it that sounds like an incredible opportunity to claim a very large tax deduction in the current year.

The problem is small business owners rarely plan for large asset purchases. This means that instead of having the cash available to buy the asset the business must take on debt.

So, while the business can claim a $30,000 deduction this year you are stuck paying off the loan, with interest, over the next 3-5 years. Overall the strategy ends up costing you more than any immediate tax you may have saved.

If your business desperately needs the asset and you were planning to buy it soon anyway then the strategy can work. Especially if you have the cash set aside to buy it. However, ideas like “you should update your work vehicle every two years because it’s good for tax” are just ridiculous.

 

Myth 2: Buying stock before the end of the year will reduce your tax bill.

At the end of each financial year businesses that carry stock need to do a stocktake. The aim of this process is to determine how much stock is being carried by the business. Comparing the stocktake numbers with your inventory system will allow you to see if any stock has been lost or stolen and update your system to accurately reflect the stock in your warehouse.

We insist that business owners do this for two main reasons:

1. To ensure that the financial data is accurate – Even if you don’t do regular stocktakes we can be sure that at least annually the levels are checked;

2. You’re closing stock value needs to be reported on your tax return. It reduces the total Cost of Goods Sold (COGS) figure we report to the tax office.

Why doesn’t buying stock help your tax bill? Because buying more stock just increases your closing stock value. Given that we can’t claim a tax deduction for closing stock all you’ve really done is lock up a lot of working capital (cash) in stock that you may not be able to sell for months.

 

Myth 3: Prepaying expenses is a great way to bring forward deductions

Many business expenses can be prepaid up to a year in advance. Depending on your situation you may be able to prepay business insurance policies, interest on loans, rent and a number of other expenses. Pre-paying expenses brings the deduction forward to the current year and reduces this year’s tax bill.

Just because you ‘can’ does not mean you ‘should’. The rule of thumb I use with my clients is as follows:

   You should consider pre-paying some business expenses if:

      1. You have the cash available to make the payment without creating cashflow distress;
      2. The vendor offers a significant discount for prepayments; and
      3. You expect next year’s business performance to be comparable to or weaker than the current year.

If the client’s answer is no to any of those three points I usually advice against making a prepayment.

 

Just “one more day”

I found the ‘Just one more day’ message in the Profit First book so useful that I’ve incorporated it into my tax planning discussion, even for clients who don’t use Profit First.

Generally speaking, Mike encourages you to look at all the major purchases you are considering. Before you make the purchase ask yourself “do I need it today or could I wait until tomorrow?”. If you could wait until tomorrow…wait!

You’ll be surprised how often ‘just one more day’ delays the purchase for over a year. If your business keeps going without experiencing any major inefficiency for a year without the item then you really didn’t need it.

 

The Tax Planning Golden Rule

Smart tax planning is crucial..but wasting money is crazy!

Work with your accountant to plan for large expenses. Accumulate money to pay in cash whenever possible and only buy when something is absolutely necessary. Deductions are great but cash is king!

 

Further Information

Read our comprehensive review of Profit First here

Join the Facebook group here

 

The 5 Stages of Implementing Profit First in Australia

The 5 Stages of Implementing Profit First in Australia

Profit First is a behavioural methodology. It seeks to achieve real change by taking advantage of your natural, human tendencies rather than trying to fight them.

The implementation process itself is not all puppy dogs and rainbows. There are plenty of challenges along the way. My aim with this article is to explore the five (5) stages that I see Profit First businesses go through on their journey to achieving the full benefits of the system.

 

1. Contemplation

You know your business has a problem. You’re working long hours, your team always seems busy but there just doesn’t seem to be anything left in the bank account at the end of each month.

You’ve read the Profit First book and the system sounds great. Mike explains it well and it seems simple enough, right?.

During this stage, you are weighing up the downsides (i.e. cost, effort, time, risk) against the benefits of making a change. Will it really be worth all the hassle? You may have even discussed the system with a Profit First Professional (as Mike recommends).

The sad truth is people can sit in this stage for years without actually moving forward.

 

2. Action – Initial Implementation

In this stage you’ve finally decided to make a change. While this is a time of great excitement you are also highly susceptible to relapse. Having a clearly defined implementation plan is crucial.

You’ll open your Profit First Bank Accounts, calculated your Current Allocation Percentages from your accounting data and use the book to work out what your Target Percentages should be.

Business owners make two crucial errors when working through this stage:

1. Opening too many bank accounts – the system becomes overly complex and drives them into relapse;

2. They miscalculate the CAPS – Any significant errors in the starting CAPS will very quickly lead to some bank accounts failing to meet their obligations. You’ll start to doubt yourself and the system. After a while, the system breaks down.

If you fail to get through the initial implementation stage your business will revert back to stage 1 and you will, again, consider whether or not the system is even worth the hassle.

 

3. Pain and Persistence

You’ve made it through the initial implementation and its time to get serious about achieving the goals in your implementation plan.

This is, by far, the most challenging stage of implementing Profit First. The initial enthusiasm and excitement may have partially (or completely) subsided. Replaced by the pain of constantly second guessing every decision you’ve ever made in your business. Why? Because it’s the only way to truly cut your operating expenses and find efficiency in your various business procedures.

Accountability in this stage is crucial. Whether it’s partners in the same business, independent business owners helping each other or a more formalised relationship with an Australian Profit First Professional.

 

4. Momentum

Congratulations, if you’ve made it this far the system is up and running! You understand what you’re doing now. You’ve cut out a lot of unnecessary ‘waste’ in your business and money is flowing between your accounts like clockwork.

As each quarter passes you’re tweaking the percentages to further improve the functioning of Profit First in your business. You may have even paid off all your debt and started to take profit distributions. How much better do you feel?

 

5. Growth

When people read the Profit First book they look at the system as a way of getting a bit more profit out of their business. I see it as so much more than that. A business that is struggling under the weight of its own expenses isn’t fun..at all! Some days you even consider closing the doors and getting a job.

On the other hand, a business that is profitable and pays you the income you deserve is far more entertaining. Business owners get their drive and passion back. On top of that, the business can suddenly afford to invest in activities that will allow it to grow without having to borrow large sums of money.

 

A happier business owner + better cashflow = business growth potential

(Another equation for you, just in case you forgot i’m an accountant!)

Things can only get better from here. Stick to the system, tweak the percentages to suit changes in your business strategy and enjoy yourself!

 

Further Information

Read our comprehensive review of Profit First here

Join the Community group here

 

Better business bookkeeping for Profit First success

Better business bookkeeping for Profit First success

One of the reasons I love Profit First is that it allows business owners to manage their cashflow and improve their profitability without the need for complex financial reports. But Profit First can’t do all the heavy lifting! You need to give yourself the best possible chance to succeed with the system. One of the ways you can xdo this is through maintaining accurate, up-to-date business records. This is where your bookkeeping process comes into play.

Given that I spent a lot of time last week providing software implementation and training I thought this was a perfect opportunity to cover off on some general areas where software can help you keep better records.

 

Bookkeeping Systems

I know you hear this all the time from your bookkeeper and/or accountant, but we harp on about this stuff for a reaso…I promise! Keeping accurate, up-to-date accounting records is crucial. Business decision making requires data and your bookkeeping is a big part of that. In fact, I doubt you could find a single business that is truly successful in the long term that hasn’t treated their accounting data as a priority.

Ok, now that I’ve had my accountant rant lets be honest..bookkeeping is really boring, right? Most days you’d rather vacuum the office and scrub the toilet than sit down and do your books. I get that. Which is why it’s so important to have the right bookkeeping system in place. The system must be:

  • Easy to maintain – if it’s overly complex to use you will get lost and make mistakes..or worse, you’ll just avoid doing it altogether;
  • Affordable – Price is relative, focus on value. You can use free systems like Wave but are they accurate? Do they provide everything your business needs (for example, payroll)? Will they grow with you?
  • Connective – It’s important to have a bookkeeping system that will integrate with external platforms. The business world is shift and the ability to export/import data for analysis is more crucial than ever.

 

My Recommendation:

When it comes to bookkeeping systems you should always choose the option that works best for you. Having said that, if you are looking for a change and not sure which way to go I’m firmly on team Xero! The system has been designed from the ground up to be far more user friendly for people who aren’t native to accounting and bookkeeping. Myob and Quickbooks are scrambling to offer viable alternatives to Australian customers but so far my experience with them has left me less than impressed.

 

Expense Capturing System

The rise of cloud-based accounting systems like Xero that are driven by data sent directly from your bank has resulted in a lazy approach to bookkeeping. What do I mean by that? Many business owners (and professional bookkeepers) wait for bank data to be imported into the accounting system and then code each line to an income or expense account. This is what accountants call ‘cash accounting’. The bookkeeping system is only recording data from bank statements which means it’s only picking up payments received and made by the business.

What’s wrong with that approach and why did I call it lazy? The issue is that it only tells half of the story.

  • Your accounting records shouldn’t just show how much income has been received from customers. You need to know how much is still receivable from them and how far overdue it is;
  • We don’t just want to see how much money you’ve spent on various expense items. You need to know how much you still owe each of your suppliers and when the payments are due.

Unfortunately, cash accounting falls short here. Thankfully most modern bookkeeping programs will allow you to generate invoices directly from the platform so that takes care of the ‘how much do our customers owe us’ side of things.

What about how much we owe? This is where expense capturing apps like Hubdoc and Receiptbank come in. These relatively inexpensive programs link directly to your bookkeeping package. They allow you to easily import electronic copies of supplier invoices and ensure you have a clear picture of how much you owe.

They are literally as simple of taking a photo with your smart phone via their app. The software scans the image and pulls out the relevant data. You check it to ensure it’s accurate before exporting the data and the image to your accounting system.

As well as being a time saver these programs also allow you to throw the paper copy of the receipt away. The electronic version is sufficient for ATO audit purposes.

 

My Recommendation:

Right now I’m loving Hubdoc. I was previously using Receiptbank but switched all my internal procedures over to Hubdoc a couple of months ago. Not only does Hubdoc help you maintain your accounts payable and store digital copies of all receipts it also has an automatic ‘fetch’ feature. Fetching allows Hubdoc to grab copies of your bank statements directly from your bank. This means your accountant and bookkeeper will stop asking for them.

 

For the Best Result – Outsource!

I know many business owners ‘can’ do their own bookkeeping and in the early stages of Profit First an easy cost to cut could be your bookkeeper. My question to you is this – Just because you can do your own bookkeeping does that mean you ‘should’? In most cases the answer is no. Bookkeeping is not part of your core skill set. It can be quite time consuming, especially if you don’t really know what you are doing. I’d prefer to see most business owners find a good quality, Australian based bookkeeper to look after their records. In the long run you and your business will be better off if you spend the hours you would have wasted on bookkeeping focused on business development activities. Do what you do best and let a professional help with the stuff you’re not so good at.

A quick side note – yes, i did say ‘Australian based’ bookkeeper. I’ve had many clients use very cheap offshore options for bookkeeping. The results have been terrible and in some cases I’ve completely deleted the file and rebuilt it from scratch because it faster than trying to fix the thousand’s of errors made.

 

How will these systems help Profit First?

Good business records are a huge help in the Profit First process. Particularly in the initial set-up phase and during any future troubleshooting.

  • Initial Set-up: great business records make the process of calculating your Current Allocation Percentages (CAPS), setting your initial percentages and starting the process of cutting costs so much easier;
  • The moment something goes wrong: For example, you realise your Opex account is starting to fall short of paying your bills. Having accurate, up-to-date business records will allow you to undertake an analysis of your spending immediately with confidence that the data you are using is correct.

 

Further Information

Read our comprehensive review of Profit First here

Join the Facebook group here