The Problem With Leaving Profits In Your Company
One of the really attractive things about companies is that profits are taxed at 26% if they meet certain conditions (if the company is trading and aggregated earnings are less than $50m per year they will qualify). It gets better still on 1 July 2021 where the rate drops to 25%. That’s a massive 22% saving in tax (and Medicare Levy) if you are in the highest marginal tax bracket. Once you earn more than $45,000 a year, where the marginal tax rate changes to 32.5%, there’s a real incentive to keep your money tucked up in your company so you don’t lose a big chunk to the taxman.
What’s wrong with that?
In my mind the only reasons to keep money (or continue growing retained earnings) in a company are:
so that it has enough working capital to trade; and
to have funds available to invest back into the business if growth is a priority.
It is not a great idea to keep money in a company because:
Cash is not protected
The first and foremost reason not to keep profits within your company is asset protection. The asset being protected in this case is your hard earned cash. While the company has a healthy balance of retained earnings you risk losing your cash to a hostile creditor. A hostile creditor might come in the form of a disgruntled employee or customer or could even be the tax office if there are outstanding debts. If the creditor is successful in their court action against you then you will lose all of what you have worked so hard for. Simply transferring excess company funds to a personal bank account doesn’t work as a strategy to mitigate this risk. Doing this results in a loan between yourself and the company; this has its own tax consequences that require consideration. If you would like to know more you can read our blog Case Study: Making a loan from your company work for you, where we discuss the implications of loans to shareholders and their associates.
There may come a day when you want to use that money for something else
In our case study referred to above there is an example of two business owners who had accumulated profits within their company. They were particularly adverse to paying tax and were taking only enough money, as a salary, to cover their living costs and lifestyle expenses. This is not at all uncommon. The day came where they decided that they wanted to renovate their home and that the surplus money in their business would be better utilised in paying for the renovation rather than sitting in a bank account earning next to no interest. If a strategy was put in place sooner to take out the surplus funds then that would have negated the need to put a loan in place with the company (such loans are commonly referred to as Division 7A loans, after the part of the Tax Act that deals with them). The company then wouldn’t have needed to pay tax on the interest that is required to be charged under such loan agreements and there may have been an opportunity to get some money out at a lower marginal rate of tax (say at 32.5% or at 37%). The case study demonstrates a great result by using a Division 7A loan, but could it have been better with more foresight?
The money is not being worked, as hard as it could, to generate personal wealth
A large proportion of accumulated profits usually sit as cash in a bank account and perhaps a term deposit earning a poor rate of return, if any thought has been put into it. This means that there is a huge lost opportunity to generate additional income from surplus company funds and that you are missing out on growing your personal wealth. The question is then: how do I best get the surplus funds out of the company? In our infographic 5 ways to pay yourself from your company we take a look at the various methods available for taking money out of your company and in our blog post Case study: How to give your business the benefits of both companies and trusts we take a deep dive into more complex structuring arrangements to protect assets and grow wealth, to help answer this question.
Final word
Managing cash can be tricky, not enough and you go out of business and too much there is a lost income earning opportunity. As a guide, the gold standard is to have access to enough working capital (sum of your cash at bank and trade debtors) to cover 3 months’ operating expenses should you not earn a cent from trading. However I would still recommend having a talk to your accountant and financial planner to ensure that you are making the best use of your cash and that it is protected from hostile creditors. If you find yourself in the situation where you need to lend money back into the company, do so by securing the loan. By doing this you make sure that you get repaid first should something go wrong.
This blog post was written in March 2021 and is in accordance with all tax rates and legislation applicable at that time.
If you would like specific advice tailored to your business and circumstances, Accounting Heart offers affordable service packages where you can work with Sonia one-on-one to help you get your business where you want it to be. Book your FREE Discovery Call to find out more.
Disclaimer: This is general information only and is not advice of any sort. No warranty or representation is provided by Accounting Heart Pty Ltd as to the accuracy, currency or completeness of the information contained in this blog. Readers of this blog should not act or refrain from acting in reliance upon any information contained herein and must always obtain appropriate taxation and / or other advice as may be appropriate having regard to their particular circumstances.