Paying yourself: salary, dividends and distributions

Many business owners take money out of their business whenever they need it and sort out what it was at the end of the year. That works until it does not: a surprise tax bill, a Division 7A problem, or a bank asking why personal spending runs through the business account. How you pay yourself depends almost entirely on your business structure, and each structure has its own rules.

This article explains the main options in general terms.

Sole traders: drawings

A sole trader and their business are the same legal person for tax purposes. You cannot pay yourself a wage, and money you take out is called drawings. Drawings are not a business expense and are not deductible.

Instead, the business's net profit is your taxable income, taxed at your personal marginal rate, whether you take the money out or leave it in the bank. The practical consequences:

• set aside money for tax as you go, because no PAYG is withheld from drawings;
• expect PAYG instalments once your business income reaches a certain level;
• keep business and personal accounts separate so the profit figure is clean.

Sole traders are not required to pay superannuation guarantee for themselves, which means retirement saving is up to you.

Partnerships: shares of profit

In a partnership, the partnership lodges a return but does not pay tax itself. Each partner is taxed on their share of the net profit under the partnership agreement. Money a partner takes out during the year is a drawing against that share, not a wage. As with sole traders, partners need to plan for their own tax.

A partnership agreement should state how profits are split, what each partner may draw, and what happens if one partner draws more than their share.

Companies: salary, dividends or both

A company is a separate legal entity. You may be a director, a shareholder and an employee all at once, and each role has a different way of being paid.

Salary or wages

If you work in the company, it can pay you a salary like any other employee. The company:

• withholds PAYG from your pay and reports it through Single Touch Payroll;
• pays superannuation guarantee, currently 12% of ordinary time earnings, on your behalf;
• claims your salary and super as deductions.

Salary gives you a regular, predictable income, builds super and creates a clear record for lenders.

Dividends

A dividend is a distribution of after-tax profit to shareholders. The company pays tax first, currently 25% for a base rate entity and 30% otherwise, and can attach franking credits to the dividend for the tax already paid. You include the dividend and the franking credit in your income and receive a credit for the company tax. If your marginal rate is below the company rate, you may get a refund; if it is above, you pay the difference.

Dividends must be properly declared, recorded in minutes and supported by profits. They cannot be paid to suit cash needs on a random Tuesday.

Director's fees

Directors can be paid fees for acting as a director. These are treated much like salary for PAYG and, generally, super purposes.

The Division 7A trap

The most common mistake in company structures is treating the company's bank account as your own. If a private company lends money or provides benefits to a shareholder or their associates, and it is not repaid or put under a complying loan agreement by the company's tax return lodgement date, Division 7A can treat the amount as an unfranked dividend. That means tax on the full amount with no franking credit.

Complying loans require minimum yearly repayments with interest at the benchmark rate. Planning ahead, and deciding at the start of the year how you will be paid, avoids most problems.

Trusts: distributions

In a discretionary (family) trust, the trustee decides each year how the trust's income is distributed among eligible beneficiaries. Beneficiaries are taxed on their share at their own rates. If income is not effectively distributed, the trustee can be taxed at the top marginal rate.

Key points:

• The resolution deadline. Trustees generally need to make the distribution decision by 30 June, or earlier if the trust deed requires it. A decision made after the year ends is usually too late.
• Read the deed. It sets out who can benefit and how income is defined.
• Unpaid entitlements. Distributing to a beneficiary and leaving the money in the trust creates an unpaid entitlement, which has its own tax rules, particularly where a company is the beneficiary.
• Reimbursement agreements. Distributing to someone on paper while the benefit goes to someone else can be caught by anti-avoidance rules.

People working in a business run through a trust can also be paid a wage by the trustee, in which case PAYG and super obligations apply as for any employee.

Personal services income

If most of your business income comes from your own personal skills or efforts, such as consulting or contracting for one main client, the personal services income rules may apply. They can attribute the income to you personally regardless of the structure, which limits the benefit of a company or trust. Whether they apply depends on specific tests and is worth checking early.

Choosing a mix

For many company owners, a combination works best: a reasonable salary that covers living costs, builds super and gives lenders a clear income history, with dividends declared from remaining profit when it suits. For trusts, the distribution decision is a yearly planning exercise, not an afterthought.

A simple example: a company makes $200,000 profit before paying its owner. Paying a $100,000 salary plus super reduces the company's taxable profit; the remaining profit is taxed in the company and can later be paid as a franked dividend. Whether that mix is efficient depends on your other income, your family situation and what you plan to do with the money.

Decide how you will be paid at the start of the year, not after it ends. Most expensive tax problems for business owners come from money taken out without a plan.

Getting the basics right

• Keep business and personal spending separate.
• Record every payment to yourself as what it is: wage, dividend, drawing, loan or distribution.
• Put money aside for tax monthly.
• Review the arrangement before 30 June each year.
• Revisit your structure if your business has grown or changed. Our business structuring work covers this.

Retirement saving is part of the picture too; see superannuation basics for business owners.

How we can help

We help business owners set up a practical way to pay themselves, plan for tax and keep the records that support it. If you are unsure whether your current arrangement is working, contact us.

This article is general information only and does not take into account your circumstances. It is not financial product advice. Speak to a qualified, licensed adviser before acting on it.