Many small business owners borrow money from their company on a regular basis. The temptation is obvious – you have access to the account, you own the company, so why not take some of the money? It’s all yours anyway, right? Not quite.
In this post we’ll run you through the good, the bad and the ugly of borrowing money from your company.
What exactly are we talking about?
If you, as a shareholder or someone affiliated with a shareholder, take money out of your company which isn’t wages or a dividend, then you’ve probably just borrowed company money. The cash could be a one-off lump sum or it could be taken out in little bits every other day. Either way, it’s a loan and could be the subject of Division 7A of the Income Tax Assessment Act 1936 which seeks to tax those doing the borrowing.
These are called “shareholder loans”, but are also commonly referred to as “directors loans”. Regardless of what you call them, there can be serious implications if they aren’t managed properly – for your tax bill and for your company’s financial health.
What’s the problem with them?
Often people borrow money from their company for reasons unconnected to their company, such as to top up their salaries. Also:
- Loans can start small, but can grow fast because they are fed by shareholders/directors drawing money from the business. Often, there’s no scrutiny of those transactions other than by the person borrowing the money.
- Under Division 7A, shareholder or directors loans are meant to be set up through a formal loan agreement, detailing interest charges and repayment terms. Often, such loans are not set up properly.
- Loans can raise red flags with the ATO when disclosed in a company tax return.
- If the loans are not administered through a proper loan agreement, you can be taxed on the entire amount.
- They can be an impediment to selling a business or bringing in employee shareholders.
When should shareholder/director loans be used?
In limited circumstances, borrowing company cash can be a smart move, especially in a tight lending market. Here are some general guidelines you can apply to see if you should or shouldn’t be borrowing company money:
- Your company has cash which is surplus to normal operational requirements (i.e. you won’t need it back in a hurry).
- The loan will only represent a small percentage of your overall company assets (e.g. <10%).
- You’ve got a compliant loan agreement in place drawn up by your tax accountant.
- You have a plan for repaying the funds, along with the associated interest charges, within the time frame specified in the loan agreement, without resorting to borrowing more company money.
When should I think twice about borrowing funds from my company?
Unfortunately, most loans of this sort aren’t the result of careful planning, but of shareholders or directors looking to solve a short term cash flow problem. Here are a few red flags that indicate you probably shouldn’t be borrowing company from your company:
- You’re using the cash to fund lifestyle expenses.
- You’re limiting the amount of cash needed to operate the business comfortably.
- You’re borrowing cash because your wage is insufficient (often because the company cannot afford the withholding tax and superannuation on a wage increase).
- You’re borrowing cash to pay personal tax bills.
- You’re not able to repay or you have no plans to repay.
The ATO has some surprisingly digestible info on this topic including a video for your viewing pleasure which you can find here.
If you need advice on company loans – maybe you’ve got surplus cash you’ve got plans for, or maybe you’ve borrowed cash without any plans – get in touch today. We’ve worked with plenty of business owners to resolve loan issues as well as the underlying cash flow difficulties that have often triggered the loan in the first instance.
Special thanks to our good friend, David Sharpe of Sharpe Advisory for lending his brain for this article.