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
- which 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 focussing on these entities.
Many business owners pay themselves in one of two ways:
They pay themselves a wage on the books, have the appropriate amount of tax 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 (and superannuation).
Or, they just take whatever they want, whenever 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 2 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.”
Sound familiar to anyone? 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.
This can contravene something called Division 7A. And yes you may be the director, the 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 and 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. That’s not a typing error, 76.5 per cent. 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 amount, 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 will 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” and sometimes you need to sacrifice paying yourself a large wage to keep the business growing and expanding and innovating to reap the future benefits.
This post originally appeared on Kochie’s Business Builders and is republished here with permission.