I am very much aware that when accountants refer to the Tax Act people’s eyes gloss over, they feel uncomfortable and would prefer to be thinking of anything else. As soon as a section of the Act is quoted it is like we are speaking in a different language and all comprehension of the issue at hand is lost. I understand as I too have been in a room of accountants who are quoting legislation (we call it professional development) and I struggle to focus as well.
But there is one important part of the legislation that you need to be aware of and you accountant may have discussed it with you in the past. It is known as Division 7A because that is the part of the Income Tax Assessment Act 1936 where the details and rules live.
In essence, Division 7A is the legislation that prevents the shareholders from taking money out of their private companies without pay tax on it. I am guessing that many of you are trading either through a company or a trust. If that is the case, Division 7A is very relevant to you. If you are sole trader, or trading as a partnership you can give this one a miss.
If you are trading as a company, the money in the company is technically not your money (yet[1]). A company is a separate legal entity, so any money in the company belongs to the company. Many business owners do not see this distinction and they use the company money for their own purposes. This money is treated as a loan from the business to the owners of the business.
Think about your business – are you paying yourselves a wage (through payroll) and only living on this wage? Or are you paying yourself a smaller wage to reduce your commitments to superannuation and workers compensation, giving you access to higher rates of family tax benefit and child care assistance, but still drawing money out of the company to meet your daily commitments? Many business owners do just that, and Division 7A is there to stop this behaviour.
Division 7A prevents money being taken out of the company unless tax is paid on it by the shareholder.
As an accountant it is very difficult to explain this to our clients who believe they are entitled to use the business money for their own needs. Sometimes it is simple things like paying for your home utilities out of the company. Possibly a portion of this can be claimed but the ATO do not allow you to deduct your home utilities just because you are in business. Often cars and fringe benefits reimbursements will increase the amount of the loan, but sometimes it is just lack of budgeting that creates the loan account. Don’t have enough money to pay for the groceries this week, I will just run it through the company. Out to lunch with my family and offer to pay for it so it can be a tax deduction? Your accountant is likely to find these expenses and move them to the loan account. It happens all the time.
How do we address this? If we notice it happening early enough we will suggest you increase your wages (without physically paying them) so we can cover these loans. Typically, we are not aware of this at an early enough stage and we will need to draw a dividend from the company to cover the loans. Dividends are taxable income and while there is usually a tax credit applied to a dividend, your overall income will be higher, you will likely need to pay tax, and you will have underestimated for family tax benefit and child care.
Alternatively, your accountant will set up a complying loan agreement to set the loan onto a commercial footing. The loan will be repaid with an interest rate advised by the ATO over a 7 year period. We call these Division 7A loans.
If you are trading from a trust the matter can be even more complicated. There are many rules in place to prevent the innovative accountant from circumventing the rules. What you need to remember is if you take the money and use it for personal expenses, you will be paying tax on it.
If you do have a Division 7A issue be guided by your accountant for a solution. It is complex and it will be a little difficult to get your head around, but a good accountant will assist you. Better still, try to prevent Division 7A issues by budgeting correctly and not thinking of the company money as your own. Draw a wage that is sufficient to cover your living needs. Pay personal expenses from personal money and business expenses from business money.
This is a very simple explanation of a very complex issue. If you are not sure if this is impacting your business please seek advice from your accountant.
[1] The owners of the company are the shareholders and they do have a right to access the company’s retained earnings by way of a dividend. Dividends are taxable income. This article is not referring to the payment of a dividend.
