The taxing problems of extracting profits from your real estate company – part 1
When it comes to owning a small to medium enterprise that is operated by a company, the taxation implications on the extraction of profits from the company is a persistent issue that often evades business owners due to the complications involved.
Business owners often fail to recognise that a company is a separate legal entity (i.e. it is treated as a separate ‘person’ from the underlying individual business owner), which has its own taxation features and obligations.
While you can extract profits from your company by simply logging into internet banking and transferring funds from the company’s bank account to yours, the tax characterisation of the amount you transferred may give rise to tax consequences of which you may not be aware.
Broadly speaking, there are only limited ways under which you may extract profits from your company, which involve the company:
- Paying you a salary or wages;
- Providing you with fringe benefits;
- Paying you a dividend;
- Providing you with a loan; or
- Buying back some of your shares in the company.
The taxation implications of these approaches are discussed below and in the next edition.
Salary or wages
Arranging for your company to remunerate you for your efforts in the form of salary and wages is by far the simplest way to extract profits from your company. You are effectively treated in exactly the same way as other employees you hired for your business. When you get paid, the company is required to withhold PAYG Withholding tax from your wages and remit the tax to the Australian Taxation Office (ATO), i.e. you will end up with a net after-tax amount in your hands. The salary or wages will be taxable in your hands and the company will be entitled to claim a tax deduction on the amounts paid to you.
If you earn gross wages of more than $450 per month, the company would also be required to make Superannuation Guarantee contributions on your behalf, which is currently calculated at 9.5 per cent of your ordinary time earnings. It is often tempting for a business owner to not make or defer the making of such contributions for themselves to give their business more cash flow but as far as the law is concerned, the company is legally obliged to make the contributions within the prescribed time frame and failure to do so would entail penalties and interest in the same way as if you have failed to make a contribution for any of your eligible employees.
Another tax trap for a business owner using a company to carry on business is the temptation to use the payment of salary or wages to split income between the owner and their family members to utilise each individual’s marginal tax rates. While there is generally nothing to prevent your company from paying wages to you and your family members as employees (with certain exceptions if the company is carrying on a business that derives ‘Personal Services Income’), the amount paid must be commensurate with the market value of the effort delivered by the relevant family member to the company, i.e. if the family member is an unrelated independent employee, what would be the arm’s length wages the company could negotiate to pay them to secure their employment?
If the ATO is of view that your company is overpaying a family member, the Commissioner of Taxation may challenge the arrangement and deny the company’s tax deduction claim on the wages on the basis that the purpose of the excess wages is to enable your family to split income and/or the dominant or sole purpose of the arrangement is for you to obtain a tax benefit. The denial of tax deductions may lead to double taxation, i.e. the company would not get the benefit of being able to reduce its taxable income by the relevant wages paid but the individual would still be liable to tax on the wages derived, which is clearly a grossly adverse tax outcome.
Rather than having the company pay a salary or wages to you, it is possible for the company to provide you with non-cash benefits as a value extraction alternative. For instance, the company may pay or reimburse your private expenditure, provide a car for your private use, etc.
While the provision of fringe benefits by the company to you as the business owner would not give rise to any income tax liability in your hands (because you did not receive any cash salary or wages), the Fringe Benefits Tax (FBT) regime would apply to tax the company on the non-cash benefits provided to you.
The idea behind FBT is that by the time the company has paid the FBT on any fringe benefit provided, both the company and the business owner would in the same tax position as if the company had paid the owner a gross salary or wages.
By way of an example, rather than a company paying you gross wages of $100, which would attract tax at the highest marginal tax rate of 47 per cent and put net wages of $100 x (100% – 47%) = $53 in your hands, if the company simply pays a private expense of $53 on your behalf, the company would become liable to FBT of about $47, which would essentially equalise the tax outcomes between the two scenarios.
Having said that, given how FBT is calculated depending on the type of fringe benefits provided (e.g. the ‘Statutory Formula Method’ in valuing car benefits), the FBT on the benefit may not always equate the income tax that would have been payable had the benefit been ‘paid out’ as gross wages.
However, such arbitration loopholes have been progressively removed over the years and there are now only limited circumstances under which modest tax savings could be achieved through the provision of fringe benefits instead of the payment of cash wages.
For example, it may be worthwhile to arrange for your company to pay your personal income protection insurance premium as the premium would not attract FBT under the ‘otherwise deductible rule’ but the company would be able to claim the GST on the premium to which you would otherwise not be entitled.
Having said that, any tax savings you achieved may further be eroded by the administrative costs on providing the fringe benefits, i.e., apart from having to process extra payments, the company would need to lodge an annual FBT Return and pay any FBT owing to the tax office.
As a word of caution, providing fringe benefits instead of paying salary or wages will actually give rise to a worse tax result if your marginal tax rate applicable to your taxable income is less than the highest marginal tax rate (currently 47 per cent inclusive of the Medicare Levy). This is because the FBT rate is set at the highest marginal tax rate, i.e. there is a fundamental assumption that those who receive non-cash fringe benefits are generally high-income earners. Therefore, there is little sense for the company to provide a fringe benefit over paying a salary or wages to you if you are paying tax at a marginal tax rate that is less than 47 per cent.
In the next edition, we will look at how you may extract value from your company via paying a dividend, drawing down a loan from the company, or returning the company’s capital to you.
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. This article is provided on the terms and understanding that the author and BDO (QLD) Pty Ltd are not responsible for the results of any actions taken on the basis of information in this article, nor for any error in or omission from this article. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.