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:
- Put all the income in your tax return and take the tax hit from the higher margin rates; or
- 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
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.
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