When it comes to paying themselves from their business, an unfortunate majority of small business owners forgo a wage or salary, preferring to simply take what they need from the business. Brad Turville, Virtual CFO at BJT Financial, explains why this is not a good idea.
This is an interesting concept because many business owners pay themselves in all sorts of interesting ways and unfortunately, in many cases, this leads to paying significantly more income tax. This in turn puts an unplanned strain on your cashflow and paints an untrue picture of your financials for valuation purposes
Your legal structure also dictates what types of consequences may be applicable, depending on how you pay yourself from your business.
As all of our clients trade via a trust (discretionary or unit), a company or a combination, we will be focusing on these entities.
Paying yourself from your business
Many business owners pay themselves in one of two ways:
- They pay themselves a salary on the books, have the appropriate amount of tax (and superannuation) withheld and remitted to ATO via their activity statements, and receive a payment summary (previously named a group certificate) at the end of financial year, or
- They just take whatever they want and have their accountant sort it out at the end of the year.
Now take a wild guess as to which is the most common method. Number two, right?
The main reason why this is the case is because many business owners have the mindset, “Well, it’s my business so I’ll pay myself whatever I want, whenever I want.”
The biggest salary trap for businesses
On the flip side, if the business is suddenly tight on cashflow, the owner has to put funds back into the business. Could you imagine the CEO of BHP getting paid, then having to transfer funds back? I don’t think so.
The biggest trap small and medium-sized business owners fall into is when they simply just take cash from the business. You must understand that it is not your cash, it is the company’s or trust’s cash, and this cash does not count as a salary.
This can also contravene something called Division 7A which states:
A payment or other benefit provided by a private company to a shareholder or their associate can be treated as a dividend for income tax purposes under Division 7A even if the participants treat it as some other form of transaction such as a loan, advance, gift or writing off a debt.
And yes, you may be the director or a shareholder and it might only be you working in the business, but that doesn’t matter – you still can’t take whatever you like.
Well, technically you can – no one can physically stop you – however, you will contravene Division 7A ITAA 1936. The total amount of cash you have taken from the business for the year will then be distributed as a ‘deemed dividend’. This means you will pay tax at your marginal rates on the amount, and the company is unable to claim a tax deduction for it.
To put it simply, this means you can pay up to 76.5 per cent tax. No, that’s not a typing error – ouch!
So what should you pay yourself?
When valuing a business, there are many adjustments that need to be made to normalise your financials.
One in particular is an adjustment for owners’ wages to market rates. You see, some business owners will pay themselves a small salary, some will pay themselves a large amount and some will not pay themselves at all.
They may pay themselves a dividend (if a company structure) or they may distribute profits to themselves (if a trust structure). Either way, the adjustment is made so the financials reflect what you would pay someone to fill your shoes.
As your business grows, it makes sense to pay yourself a market rate for the role you fill. If you are a plumber, pay yourself a wage equal to what it would cost to employ someone to fill your shoes. If you are a veterinarian, then the same applies.
If you want a little bonus at the end of the year, or perhaps six months into the financial year, you can pay yourself an employee bonus, a directors’ fee or even a fully franked dividend. However this is definitely something you should speak to your accountant about first, and should be part of your tax planning each and every financial year.
The point to keep in mind is that ‘cashflow is king’. Sometimes you need to sacrifice paying yourself a large wage or salary to keep the business growing and expanding and innovating – to reap the future benefits.
This post was originally published on Kochie’s Business Builders, read the original here.
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