Many business owners, when starting out, often incorporate their business as a Company due to the attractions of paying tax at a flat rate. However, what many don’t realise is that the Company tax rate will only apply until money is withdrawn from the Company. Following this, an additional rate of tax may be applicable, dependent on the recipient’s circumstances.
Generally, when operating as a Company, Shareholders have three options as to how they can extract profits from the business; through the payment of dividends, a salary or drawings.
Receiving dividends from the business
Dividends are paid out of a Company’s post tax profits, i.e. profits which the Company has already paid tax on (currently 30%).
To ensure Shareholders are not taxed twice on the profit distributed as a dividend, a franking credit equal to the amount of tax paid by the Company (i.e. 30%) is attached to the dividend which the Shareholder can utilise to reduce their tax liability associated with the dividend.
The Shareholder is required to declare the dividends as income and pay tax on the dividends grossed up value (which includes the franking credit).
However, there are additional costs when paying a dividend which business owners may incur, including the payment of additional tax on benefits, such as the Medicare Levy or the complication of having to pay PAYG instalment tax.
For more information about how dividends are paid , take a look at LawPath’s post about company constitutions!
Taking a salary from the business;
The second option for Shareholder’s to take money out of a business is through a salary.
Shareholder’s who pay themselves a salary are generally treated in the same way as their employees. This will result in PAYG withholding payments as well as superannuation guarantee contributions, WorkCover insurance premiums and other potential costs. Although this sounds disadvantageous, the simplicity of receiving a recurring salary, from both a tax and budgeting perspective, is an attractive setup.
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Receiving Drawings from the business
Drawings are a way for Shareholders to withdraw money from the business without paying PAYG withholding payments or the other costs as outlined above. Under Australian Tax legislation, drawings are treated as a loan from the Company to the shareholder and require the formalisation of a loan agreement including interest payable by the Shareholder to the Company. As a result, the Shareholder will still be required to pay interest back to the Company as well as tax on the cash received – however it will be over a longer period.
Where a loan agreement and interest charge are not put in place by year end, the drawings will be treated as unfranked dividends to the Shareholders, with tax payable at their marginal rates.
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