One of the biggest problems I see happens when business owners decide to take money out of their company.
Understanding the implications of withdrawing funds and the rules around what you can and can’t do can start to be confusing, particularly if you’re pulling money out as a loan to yourself. There are a lot of misconceptions and errors which all tend to lead to one thing: an unexpected bill.
I’ve listed the three main ways to withdraw cash from your business and the basics of what you need to know below.
Three ways to withdraw funds from your company
1. Pay yourself a salary
The most straightforward method of extracting money from a company is by paying yourself a salary or wage.
When you do this, you’re giving yourself an income and you will have to pay tax on it just as a PAYG employee does. This tax is separate from the tax your company has to pay - but the salary you pay yourself is a deduction to your company.
Don’t forget, you’ll also need to pay yourself superannuation, which is in addition to the salary. If paid on time, this also counts as a deduction at the time of payment.
The primary benefit of this method of withdrawing cash from your business is its simplicity and compliance with tax laws. Keep in mind that paying yourself will influence your company’s cash flow and profits. Taking into consideration the available profit and cash, you should aim to have the amount you ‘earn’ in line with what a paid professional in a similar role would take home. This will hopefully allow for investment back into your business.
2. Dividends
Dividends are another common method of extracting funds. This option is available when a company has generated profits. Dividends can be either franked or unfranked:
Franked Dividends: These are paid out of profits that have already been taxed at the company level. The tax paid becomes a “franking credit”, and accompanies the dividend when paid. This credit acts as income, but also creates a tax credit for the shareholder to offset the tax bill.
Unfranked Dividends: These dividends do not have accompanying franking credits, and as such the shareholder receives the full tax burden of the income.
While paying yourself dividends can be a tax-efficient way of distributing profits, they can only be paid out if your company is actually profitable. Additionally, if your business is newly established or has experienced losses in previous years, this strategy may not be feasible.
This topic can be complex so reach out for more information.
3. Loans and Division 7A
Now for the most complicated option:
Taking a loan from your company is another method of withdrawing cash. Business owners often decide to access either a lump sum (or drips and drabs over the course of a year), but doing this comes with specific rules and risks thanks to Division 7A of the Income Tax Assessment Act.
Here’s what you need to know:
Loan structure: If you (being a shareholder or an associate of the shareholder) take money from the company and do not classify it as a wage or dividend, it must be considered as a loan. This loan must be repaid within 7 years (unless it is secured against a real property, in which case you get 25 years), and has to meet the ATO interest requirements.
Interest rates and terms: The loan must comply with specific terms set by the Australian Taxation Office (ATO). For the 2023-24 financial year, the interest rate is set at 8.24%, which is relatively high. Additionally, there are mandatory minimum repayments that must be met — you can’t just take out a lump sum with the plan to repay it in one go in a few years time.
Be aware: If you don’t have the correct documentation in place when you tap into company funds for a loan, you might face costs to do so retrospectively.
One more thing: One significant risk of this strategy is falling out of compliance with any additional license requirements. For example, the QBCC does not count Division 7A loans towards its tangible assets test unless strict criteria are met.
Common misconceptions about company loans
Business owners run into trouble because they believe they can borrow money from their company, pay it back at the end of the financial year, then withdraw it again shortly after. The ATO is aware of this practice and has implemented ‘section 109R’ to deem this repayment strategy invalid. This means that unless the repayment is genuine and not intended to circumvent Division 7A rules, it will be considered as non-compliant.
The other problem that comes up is confusion about tax. Unless the withdrawal of funds is used for another income-producing opportunity such as funding an investment property purchase, the interest will become non-deductible in the Director’s name, but tax will still need to be paid by the company for the interest it has earned from the loan. All of a sudden you’ll have an income amount that doesn’t have a corresponding deduction, which can lead to more tax being paid.
Failure to comply with the rules around a Division 7A loan can also result in severe financial consequences, including your entire loan being deemed a dividend and attracting higher taxes.
I’m not saying never withdraw company money as a loan because doing so can work really well if you follow the rules and have the right plan to follow. The key takeaway is to engage with your accountant so you can minimise the risk of non-compliance and protect your company’s financial health.
The final advice? Before you take money from your company, touch base with your accountant. We can work out the relevant requirements in relation to documentation and tax, so you can be compliant and avoid an unexpected bill.
Want help to pay dividends or borrow from your business? Reach out to JVP Advisory today.