Case Study: Making A Loan From Your Company Work For You
I’m not usually a fan of making loans from companies. The most frequent use of them is purely reactionary, to delay paying tax. These loans often arise when a shareholder or one of their associates pays for personal expenses or simply withdraws cash from the company bank account without processing these transactions through payroll (and therefore paying PAYG withholding and super). If left unchecked, what usually results is a large sum of money being owed to the company at the end of the financial year. The ATO requires the loan to be repaid in full at the time the company’s tax return is lodged or a complying loan agreement is put in place otherwise they will deem an unfranked dividend. The unfranked dividend most often results in the shareholder (or associate) with a large and unexpected tax bill.
Putting in a reactionary loan agreement allows the shareholder to repay the loan over time and therefore spreads the tax liability over a number of years. The most common way of repaying the loan is by journal entry (some people call it paper money, as it is not real money). The loan is shown as a dividend or bonus type payment to the shareholder in the accounts of the company and the shareholder includes the income in their tax return, even though they didn’t physically get the cash. The other sting in the tail is the company must calculate interest on the loan. This is payable by the shareholder (again usually via journal entry) and must be included as income in the company tax return and tax paid on it.
You might hear your accountant refer to these types of loans as Division 7A loans and the loan agreements as Division 7A loan agreements. Division 7A refers to the part of the Tax Act that deals with loans from companies to shareholders or their associates. The important features of Division 7A loans are:
The maximum term for an unsecured loan is 7 years
The maximum term for a secured loan is 25 years
Interest is calculated on the loan at the Division 7A Benchmark interest rate. This is updated each year and published by the ATO
If properly planned a Division 7A loan is not always a bad thing.
Case study
Let’s take a look at how Elizabeth and James use such a loan to help pay for renovations to their home, and both the savings in tax and bank interest they achieved. All of our calculations, supporting the numbers mentioned in this case study, can be viewed here.
Facts
The facts for this case study are:
Elizabeth and James own a legal practice where they are both shareholders;
They both work in the practice as lawyers, draw salaries and have a taxable income of $170,000 each per year;
Over the years they’ve been in practice they’d accumulated $200,000 in retained earnings in the company;
The bank account had a balance of $150,000 at 30 June 2018;
Elizabeth and James decided to do some renovations on their home;
The estimated cost of the renovations was $200,000, without allowing for any contingencies;
A bank loan was obtained for $200,000 to fund the renovations;
Prior to starting the renovations (May 2018) the client met with us to discuss their plans as they were concerned the amount of funding from the bank only covered the contracted value of the renovations and did not allow for any variations. They wanted to know if any of the surplus money in the company could be put towards the renovations;
The renovations commenced 6 months later (November 2018) and the variations started to accumulate, and
At the end of the project (April 2019) there were total variations of $80,000.
The issue
The issue in the case was to decide on how to best take the money out of the company and not be faced with an insurmountable tax bill. If the full amount of $80,000 were taken from the company as a lump sum after tax bonus to pay for the variations then Elizabeth and James’ company would have been left with a PAYG withholding bill of $67,924 (calculation 1, reference H). What’s important to remember here is the renovations need to be paid from Elizabeth and James’ after tax dollars, so to receive $80,000 after tax they would need to be paid a gross combined amount of $147,924 (calculation 1, reference G) from the company.
The solution
We put a plan in place using a Division 7A loan so instead of the company paying PAYG withholding $67,924 (calculation 1, reference H) on bonus payments in a single year, the PAYG withholding payments would be $54,603 (calculation 2, reference line K) spread out over seven years. There is tax to pay on interest charged on the loan that totals $1,425 (calculation 2, reference line L), resulting in total tax payable of $56,028. Therefore by putting the plan in place Elizabeth and James save $11,896 in tax.
Furthermore, if Elizabeth and James went back to their bank for a further loan of $80,000 they would have had interest somewhere in the order of $5,244 to pay (calculation 3). Instead of paying this money to a bank they paid $1,425 additional tax to the ATO on the interest income to the company. This resulted in a further estimated saving of $3,819.
The total savings of this strategy are in the order of $15,715.
The details
For anyone who loves details, the details of the plan were this:
Year ended 30 June 2018
In anticipation of variations being inevitable, it was decided to take some of the money out in the 2018 financial year. $20,000 in total or $10,000 each could be taken without going into the top marginal rate of tax (calculation 1, reference A) so it was agreed this was the amount to be taken as a bonus. The tax on this amount was $7,800 and the net payment to Elizabeth and James was $12,200 (calculation 1, references B & C).
Year ended 30 June 2019
The project was completed, an additional $80,000 had been spent on the renovations over and above the contracted price. This money had been withdrawn from the company bank account, at the time the renovation was completed, to pay the builder. In the 2019 financial year it was decided to pay another gross bonus of $20,000 in total. After tax this meant the amount owing to the company was $55,600 at 30 June 2019 (calculation 2, reference line A).
Year ended 30 June 2020
It was the client’s preference for the remaining loan from the company to be rapid in a manner that didn’t require them to go over the $180,000 threshold pushing them into the top marginal rate of tax. On 1 July 2019 another gross bonus of $20,000 was paid, resulting in a loan balance of $43,400 (calculation 2, reference line B).
Before the tax return was lodged a Division 7A loan agreement was entered into for $55,600, the outstanding balance of the loan at 30 June 2020. As there was a repayment of the loan on 1 July 2020 interest is only payable on $43,400 for the year at a rate of 5.37%, being the Division 7A benchmark interest rate for 2020, totalling $2,330.58 (calculation 2, reference line C). The resulting increase in company tax is $640.75 (calculation 2, reference line C). The balance of the loans at 30 June 2020 is $45,731 (calculation 2, reference line C).
Year ended 30 June 2021 & beyond
On 1 July 2020 a further gross bonus of $20,000 was paid and the loan balance was reduced to $33,531 (calculation 2, reference line D). Interest is calculated at the end of the 2021 financial year at a rate of 4.52% and will be $1,515.58 and the loan balance $35,046 (calculation 2, reference line E). This continues each year until the loan is repaid on 1 July 2023 (calculation 2, reference lines F - J).
What’s not considered in this case study
This case study doesn’t consider the tax benefit of the deduction that the company is entitled to for the payment of the bonuses, nor does it consider the requirement to pay superannuation on some forms of bonus payments.
You may be wondering why we did the payments as bonuses rather than franked dividends. We consider the payment of bonuses/directors fees versus bonuses in our case study Dividend, bonus, or directors fee which is better?
A final word
If you are considering such a strategy getting advice is absolutely critical. One of the reasons that this strategy worked so well was that the client sought advice early, giving them plenty of time to get money out of the company prior to a loan agreement needing to be entered into.
You may also be wondering why Elizabeth and James didn’t start taking profits from the company sooner and achieve an even better tax result. We look at this in our blog post The problem with leaving profits in your company.
This blog post was written in March 2021 and is in accordance with all tax rates and legislation applicable at that time.
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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.