Division 7A: What Every Private Company Owner Needs to Know
One of the many benefits of running an enterprise through a private company is the flat tax rate of 25% for small business and 30% for other companies. But where the individuals associated with that company wish to draw funds for personal purposes, there are specific rules that ensure that these are taxed appropriately.
Division 7A is legislation designed to prevent private companies from distributing profits to shareholders or their associates in the form of loans, payments, or debt forgiveness instead of taxable dividends or wages.
A common example of this is for a business owner to transfer money to themselves over and above their wage or for the business owner to pay for something on the company credit card that is not deductible.
Whilst the rules are relatively complex, here is a summary of what you need to know.
When does Division 7A apply?
Division 7A applies when a private company provides financial benefits to shareholders or their associates without proper structuring. This can include:
1. Loans: Funds provided to shareholders or their associates without formal loan agreements or appropriate terms.
Example: A company transfers $100,000 to the director’s personal bank account without a loan agreement.
2. Payments: Direct payments made on behalf of shareholders or their associates.
Example: A company pays a shareholder’s home mortgage repayments.
3. Debt Forgiveness: When a company forgives a debt owed by a shareholder or their associate.
Example: A director borrows $50,000 from the company but cannot repay it so the company writes off the debt.
4. Use of Company Assets: Allowing shareholders or their associates to use company assets without proper compensation.
Example: A company owns a holiday home that the director and their family use rent-free or at less than commercial terms.
Why is Division 7A so important?
1. Companies are separate legal entities which is why they are so popular for asset protection. However it also means that the company assets belong to the company, not the associated individuals.
2. Significant tax consequences.
If Division 7A applies, the benefit received is treated as an unfranked dividend. This means:
- No franking credits: unlike regular dividends, unfranked dividends do not carry franking credits, leading to higher tax liabilities.
- Higher personal tax rates: the recipient pays tax at their marginal tax rate, which can be as high as 47%, compared to the company tax rate of 25% or 30%.
Example: If a business owner takes out $200,000 from the company without structuring it as a loan or salary, and they are in the highest tax bracket (47%), they could incur up to $94,000 in personal tax.
3. Risk of ATO audits and penalties.
The ATO actively monitors transactions that could trigger Division 7A and imposes significant penalties for non-compliance, including:
- Additional interest charges on unpaid or misclassified amounts
- Increased scrutiny in company audits
- Potential legal consequences for repeated non-compliance.
Structuring Loans Correctly
Not all loans from a private company trigger Division 7A if they are structured properly. To comply, business owners should:
1. Have a formal loan agreement: ensure the loan is under a formal written agreement.
2. Use a benchmark interest rate: charge and pay interest at the ATO’s benchmark interest rate (e.g., 8.27% for FY 2024-25).
3. Follow the maximum repayment terms:
• 7 years for unsecured loans
• 25 years for loans secured against real property
Example: A director borrows $150,000 from the company under a structured loan agreement with a 7-year term, paying interest at the ATO’s benchmark rate. This avoids Division 7A implications.
Common Pitfalls and How to Avoid Them
1. Using company funds for personal expenses
Best practice: Always distinguish between business and personal finances by keeping clear accounting records.
2. Failing to document transactions
Best practice: Ensure all loans have formal agreements and meet repayment terms.
3. Not making minimum loan repayments
Best practice: Make required repayments each year to prevent the loan from being classified as an assessable dividend.
4. Debt forgiveness
Best practice: Avoid forgiving loans unless structured correctly with tax planning advice.
Strategies to Manage Division 7A Risks
- Declare dividends properly: instead of drawing money as an informal loan, declare dividends with franking credits where appropriate.
- Use a trust or service entity: structuring business operations through discretionary trusts or service entities may help manage tax implications.
- Repay loans on time: ensure minimum repayments are met annually to avoid reclassification as an unfranked dividend.
- Seek professional advice: consulting an accountant or tax professional can help navigate Division 7A effectively and ensure compliance.
How Patison Accountants & Advisors Can Help
We specialise in navigating Division 7A compliance and structuring company loans correctly. Contact us to discuss how to:
- Avoid unnecessary tax liabilities
- Ensure ATO-compliant loan structuring
- Minimise Division 7A risks.
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