Understanding the flow of money in and out of your company: A guide to owner compensation and tax implications

There are many ways owners seek compensation from their company, such as dividends, salaries, employment opportunities for family members, cash advances, and personal expenses charged to the company. But it is important to remember that once the money enters the company, it becomes company funds which presents some complexities. In this blog post, we explore the flow of money in and out of a company structure and the common pitfalls that owners may encounter.

Loans

When you lend money to your own company, you can eventually get it back by repaying it. Keep in mind that the repayment itself will not count as a deductible expense for the company. However, if you charged interest on the loan and the money was used for business activities, then the interest payments made to you can be tax-deductible.

On the other hand, if your company makes payments on the principal of the loan, that money will not be considered taxable income. But any interest that you earn will need to be reported on your income tax return. It is important to keep track of all loan details, such as the loan term and repayment plan, and document them accordingly.

Dividends

In simple terms, dividends are profits paid out to a company’s shareholders. If the company has paid income tax, it might have franking credits. This means that dividends paid to shareholders might be franked, and shareholders can use these credits to reduce their personal tax liabilities.

For private companies, a distribution statement must be provided to shareholders within four months after the end of the financial year, which gives the company enough time to work out the extent to which dividends will be franked.

If any shares in the company are held by a discretionary trust, there are additional factors to consider, including whether the trust has net income for the year, whether it has made a family trust election for tax purposes, and who will become entitled to any distributions made by the trust for that year.

Share capital

If a company has a large share capital balance, the company may be able to repay some of the capital to its shareholders. However, the ability to do so depends on the company’s constitution and there are legal factors that should be considered.

From a tax perspective, returning share capital generally reduces the cost base of the shares for capital gains tax purposes. This means that there could be a larger capital gain when the shares are sold in the future, but there may not be an immediate tax liability. However, it is important to be aware of the integrity rules in the tax system that could be triggered, especially if the company has retained profits that could be distributed as dividends. 

Shareholder loans, payments, and forgiven debts 

There are rules in the tax law (Division 7A) that prevent business owners from accessing funds in a way that avoids income tax. Under Division 7A, any payments, loans, or forgiven debts are treated as if they were dividends for tax purposes unless there is a loan agreement in place that meets certain requirements.

To avoid this ‘deemed’ dividend being triggered, you must ensure that the loan is fully repaid or placed under a complying loan agreement before the due date or actual lodgement date of the company’s tax return. The minimum benchmark interest rate that applies for complying loan agreements is currently 4.77% for 2022-23.

For instance, if you take money out of the company bank account to pay for personal expenses, like school fees or home loans, and fail to repay it or put a complying loan agreement in place, it will be treated as a deemed unfranked dividend. This means you will have to declare it in your personal income tax return as if it were a dividend without the benefit of any franking credits. You will be taxed on it again, even though the company may have already paid tax on the same amount, causing double taxation of the same company profits.

It is important to manage the loan repayments carefully to avoid adverse tax implications. If a repayment is made, but the same amount or more is loaned to the shareholder shortly afterwards, some special rules can apply to ignore the repayment. There are some exceptions to these rules, and it is crucial to ensure the position is managed carefully to avoid any negative tax implications.

Summary

Moving money in and out of a company can be a complex process. It is important to understand the different options available and the tax implications associated with each one. The Acceler Advisory team can help you can avoid common pitfalls and ensure that your business finances are managed effectively.

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