Director Loans for Business Owners: advantages, traps and pitfalls of Division 7A Loans
When you first start a business, often the only person prepared to lend to you is yourself. It is, therefore tempting to loan money from the business to fund your personal expenses. Any loan from a private company to a shareholder of that company, or associate of a shareholder of that company, is known as a Division 7A loan. Loans of this type are subject to a range of strictly applied rules, which must be carefully adhered to.The Division 7a rules, although strict, offer concessions. If used with care, they can provide much-needed support for a business owner. But if applied recklessly can lead to severe financial stress for the business owner.
Generally, a working director of a company can receive income in one of two ways:
- Earning a regular salary as an employee.
The company will withhold PAYG tax from your salary and remit it to the Australian Taxation Office (ATO).
This method is generally considered the least tax-efficient way to be paid. However, lower salaries can be balanced with dividends. And it’s much easier to manage and include in your company’s cash flow. Yes, you’ll have higher BAS/IAS bills each month. But you’ll always know how much you’re getting (and how much you’re taking from your company). Also, you won’t have to pay anything extra on your personal tax return.
- Drawing money from the company, which accrues as a Shareholder Loan account on the balance sheet.
This involves drawing cash as you need it from the company without withholding any tax. At the end of the year, you receive a notional year-end dividend from the company’s profits, which is then offset against your loan account.
Once a dividend is declared, you will deal with the income tax through the shareholders' tax return, which may result in a tax bill. We don’t recommend declaring dividends until the company has paid the tax, as you will want the dividend to be “franked”. Unfranked dividends provide no tax benefit. With a franked dividend, depending on the earnings of the shareholder, there will be a refund if the company tax is higher than the shareholder’s marginal tax rate. Or there will be a top-up tax if the shareholder’s marginal rate is higher than the company tax rate. Depending on the amount of drawings the Accountant may advise to leave a balance in the Loan account and declare franked dividends under the Division 7A rules.
What is a Division 7A loan?
Any loan from a private company to a shareholder of that company, or associate of a shareholder of that company, is subject to Division 7A rules. Associates of a shareholder broadly include spouses and family members, as well as trusts that are controlled by those people.
The Division 7A rules seek to prevent money being taken out of private companies by way of loans or other benefits provided, where it results in an individual or their associate benefiting from the company’s funds without paying tax on the money that has been withdrawn. When taking money out of a company via either wages or dividends, the individual must pay tax on that income at their marginal rate. However, when a loan is provided, the individual is receiving the benefit of those funds without having paid tax on them.
Cameron is a small business owner trading through a company. She withdrew $200k from the company during the 18/19 year. Cameron is a 100% shareholder. During the year she treated $90k as wages and withheld the appropriate amount of PAYGW tax. At the end of the year Cameron with her Accountant could either:
- Amend the last quarter BAS and increase Cameron’s wages and increase the PAYGW;
- Include a franked dividend in her tax return for either the full amount, partial amount or none of the untaxed balance. If any balance of the $200k drawings is not included in Cameron’s 18/19 tax return, there will be a Loan Balance. Assuming Cameron has used the funds for personal use, e.g. school fees, holidays and dining out, the untaxed balance will fall under the Division 7A umbrella. If the advance was used on a commercial basis, this would not be a Division 7A Loan. For example, if the company borrowed money from the bank and on-lent to Cameron for business investment, and she is repaying the company according to bank terms.
What are the terms of a Division 7A loan?
Interest is calculated from 1 July after the loan/drawings taken using an interest rate determined by the ATO for these loans. The rate is released annually and is 5.20% for the 2018/19 financial year.
There will be a formal loan agreement between the shareholder and the company where minimum yearly repayments are required. A seven-year term applies for unsecured loans or a 25-years for secured loans. Cash or notional dividends are used for repayments.
What are the advantages of a Division 7A loan?
A Division 7A loan is like a personal loan and as such is “bad debt”. (1) However, the loan is between you and your company rather than a financial institution, and no repayment is generally required in the first 12 months. The interest rate is more concessional than a personal loan rate and certainly better than credit card loan rates.
Just as home loan debt can lead to growth in personal wealth, a Division 7A loan can provide an owner of a new start-up business with some much-needed funding.
What are the Pitfalls of a Division 7A loan?
Just as some taxpayers rely too heavily on credit card or home loan debt, some small business taxpayers overuse division 7A loan debt. Some business taxpayers may not even be aware of the debt. Some accountants may use the provision incorrectly or not report its consequences to the taxpayer. The Division 7A provisions include rules to protect the integrity of the concessions. The rules need to be followed strictly and if some of the conditions are not met, the entire value of that loan/benefit may be deemed to be an unfranked dividend to the shareholder or associate. This means the shareholder or associate is taxed on the full value of the loan/benefit with no access to franking credits. If you withdrew $100,000 and were already on the top marginal rate, that would be a $47,000 tax bill!
In addition, the loan should not be too large, because the repayment amount plus franking credits could bring the shareholder into a higher tax bracket.
How to Avoid the Pitfalls of Division 7A loan rules
- Review the financial statements prepared for the company when you receive your tax return. Ask your Accountant about any Current or Non-Current Assets that say Loan Shareholder/Director.
- Ensure your Accountant is thoroughly familiar with Division 7A rules and that you have received a Division 7A loan agreement if a loan has been created. It should not be necessary to secure an agreement for every loan. Once an appropriately worded loan document is created, it should cover all future loans between you and the company.
- Ensure Division 7A loans decrease from year to year and are used only to finance particular events. For example, a small business start-up or a temporary downturn.
- Always discuss any plan to use company funds to fund personal/private expenditure with your Accountant, as these plans may breach Division 7A rules.
In summary, Division 7A loans can be an effective way to meet some funding requirements in the early years of a business start-up or during a temporary down turn, but should not be used on an ongoing basis.
If you would like assistance, please contact us.
(1) A “good debt” is borrowing for an investment or investment property, and the interest expense is tax-deductible. A “bad debt” is for personal/private expenditure where the interest expense is not deductible.