Some accountants recommend that clients start Div7A Director’s loans with their companies in order to save on tax. In most circumstances I don’t recommend that and here is why….
When you operate a company the company trades and owns the income and cash that the business generates. The company pays its workers including the owners, for the work they do in the form of wages & salaries.
When you take money from your company you should be sure to record it as a wage with Pay As You Go Withholding tax.
If you take funds from your company and don’t record it in the wages system, you have created a director’s loan. These can be hugely problematic and if not dealt with correctly, will be taxed at an effective tax rate of up to 74%!
Let me explain more. The ATO requires that these loans to be treated as unfranked dividends. Essentially the company forgoes a tax deduction at 25% and the individual receiving the amount pays full tax on the amount up to 49%.
We can prevent the loan being treated as an unfranked dividend by entering into a complying loan agreement know as a Division 7A loan agreement. This puts the loan on a commercial footing. The ATO dictates the interest rate charged by the company to the directors and also dictates the minimum amount that must be paid off the loan each year. It’s generally paid off over 7 years.
Each year loans are treated a new loans and recorded in the company’s books as sperate loans.
Benefits of Division 7A loans:
- In the year that the director takes the loan from the company, no tax is payable.
Disadvantages of Division 7A Loans:
- Most often we pay a dividend from the company to cover the minimum repayments and directors pay top up tax. That is the difference between the company rate of tax and the individuals rate of tax. That happens every year from year 2 to year 7 of the loan.
- The interest calculated on the loan is taxable income for the company and not tax deductible to the individual.
- Substantial accountings fees are charged for work on each separate loan every year as the calculation must be made and dividends declared with minutes before the end of the financial year. This is why accountants love these loans.
- In the years after year one when the loan is taken, clients feel that they are paying huge amounts of tax. Any they’re right. By year three most business struggle to generate enough profit to pay the dividend.
- Division 7A loans might feel great in year one, but they are a certain path to cashflow problems and can cause financial collapse.
Please contact us if you would like more assistance. Janelle Bartlett FCA (Author)
