Introduction: The Complexities of Borrowing from Your Business
Borrowing money from your own business isn’t as straightforward as taking out a personal loan from a bank. The process involves navigating a maze of business loans, tax regulations, and financial documentation. Whether you’re considering equipment finance to buy vehicles or machinery, using invoice financing to unlock cash from outstanding invoices, or simply looking to boost your working capital, it’s crucial to understand how these loan options impact your business’s cash flow and overall financial health.
A well-maintained cash flow statement is essential for tracking the movement of money in and out of your company, especially when you’re using business assets or physical assets as collateral. If you’re seeking funds for start up costs or to expand your operations, knowing the ins and outs of business finance can help you make informed decisions. Each type of business loan—whether for a lump sum investment or ongoing financing—comes with its own set of rules, risks, and tax implications. By understanding the complexities of borrowing from your business, you can ensure that your financing choices support your long-term business goals and keep you compliant with tax law.
Eligibility and Requirements
Before you can access a business loan, it’s important to meet certain eligibility criteria set by lenders and regulatory bodies. Most lenders will require you to present a comprehensive business plan that outlines your business goals, projected income, and how you intend to use the funds. Up-to-date financial statements are also essential, as they provide a snapshot of your company’s financial health and help lenders assess your ability to repay the loan.
If you’re considering unsecured business loans, be prepared for a higher interest rate, as these loans carry more risk for the lender. Private companies must also ensure compliance with the Income Tax Assessment Act and other relevant tax laws, which may affect the types of loans available and the documentation required. The loan term, interest rate, and repayment options will vary depending on the loan type—secured loans may require business assets as collateral, while unsecured loans rely more heavily on your credit history and business performance.
For example, an overdraft facility might be suitable for managing short-term cash flow gaps, while a secured loan could be ideal for purchasing commercial property or equipment. Understanding the specific requirements for each loan type will help you choose the best option for your business and ensure a smoother application process.
Taking out a company loan is tricky. Find out how to borrow money and comply with the tax law.
When you think of taking out a loan, you probably think of banks and other lenders. That’s the traditional place to borrow money, so it’s the go-to in most people’s minds.
However, under special circumstances, it may be possible to borrow money from a business.
Taking out a loan from a business is a tricky endeavour. It’s a lot different from the personal loans you may be familiar with.
In some cases, tax implications and restrictions can be so different that you may think the headache isn’t worth it.
As they say, the devil is in the details.
But by doing it right, you may see benefits that you don’t typically get from a bank loan. For example, some business loans may offer lower interest rates, making them a more cost-effective option. Additionally, you might benefit from fast access to funds, with approvals and disbursements happening much quicker than with traditional bank loans.
Read more about borrowing money from a business to find out if this is the right option for you.
Loan Types
Can a business loan money to an individual? The short answer is “yes”.
But it’s complicated…
Unlike banks and lenders, a stranger can’t come into a business and ask for a loan. You need to have an existing relationship with the business loaning the money, whether it’s as a director or an employee. Businesses may also offer loans or special terms to those with an established relationship, much like how banks provide discounts or special offers to their existing customers.
There are two different types of loans available to individuals. They are: In some cases, eligibility for these loans may be similar to small business loans, where factors such as financial documentation and the relationship with the business are considered.
Division 7A (Director/Shareholder Loan)
If you’re the director or owner of a company, you can borrow money from the company. These loans are also called shareholder loans or Division 7A loans.
Directors and shareholders can take advantage of the Division 7A provision of the Income Tax Assessment Act 1936. Under this provision, borrowers usually don’t have to pay tax on the amount of the loan. The timing of when the loan amount is considered to be made or recognized under Division 7A is based on when the amount is paid to the shareholder or their associate.
The income tax assessment act prevents companies from abusing the tax code. This can include giving tax-free profits or assets to shareholders. Companies that pay company tax generally hold the funds held in a Franking Account. The funds in this account go to the shareholders.
Companies don’t pay a tax on shareholder loans. Division 7A marked dividends are generally unfranked dividends. This means that no tax goes into a Franking Account.
Franked and unfranked dividends are usually disclosed in a tax return. However, the ramifications of paying franked versus unfranked dividends may depend on the company.
These loans apply to any money borrowed that doesn’t count as dividends or wages. And it can apply no matter how the payout occurs.
For example, you can take out a lump sum for a major expense. Or you can take out a loan in several instances for ongoing expenses. But they all fall under the same Division 7A umbrella.
Ideally, these loans are set up through a formal loan agreement. The agreement contains important details like terms, interest charge, and interest rate type, which can be fixed or variable. Many companies don’t take the time to set up these loans properly and that could lead to problems down the line, such as capital gains. It’s also important to note that each payment made towards the loan reduces the outstanding balance and helps ensure compliance with tax laws.
Keep in mind, though, that these loans can grow out of hand quickly. Only the person borrowing the money knows about the transactions, so they can start off small but grow quickly. Before you know it, shareholders are drawing more money than the business takes in. It is crucial to ensure the business has enough money before making loans to avoid financial strain. Additionally, tracking the money coming into the business is essential to prevent cash flow issues.
Ultimately, this may affect the overall financial health of the business.
So, when should you use a director loan?
These loans are a smart move if you reserve them for special circumstances like:
- The business has a cash surplus
- A tax accountant draws up a compliant loan agreement
- The borrowed money is less than 10% of the overall company assets
Also, responsible borrowing tactics are important here. But it’s especially important to have a plan when taking out money from your own company. All loan transactions should be tracked through the business account to maintain accurate records.
Shareholder loans typically have generous terms of repayment. You have seven years to repay an unsecured loan while secured loans may be repaid over 25 years. Secured loans often require collateral, such as residential property, to guarantee repayment. An asset like property, equipment, or inventory can be used as security for a loan.
It’s too easy to fall into the trap of borrowing more to cover the shortfall, which will only hurt your business in the end.
At the same time, small business owners may want to borrow money to take care of cash flow problems. But this is a short-term solution at best because you’ll have to repay the money just like any other loan.
If you’re thinking about taking out a director’s loan, remember that it’s meant to cover business-related expenses. Using it for any other reason may lower your ability to run a successful business.
Fringe Benefits (Employee Loan)
Fringe benefits are generally offered in a salary package. It’s also called salary sacrifice because you give up a part of your income after tax. In return, though, the employer pays for certain agreed-upon benefits out of your pre-tax salary.
Things like a car or phone are common fringe benefits people may receive from an employer. It looks like this:
If you receive a $100,000 salary, you can divide that into $85,000 of income and a $15,000 car as a benefit. Even though your salary is $100,00, you pay less tax because your actual taxable income is $85,000.
Fringe benefits can also include loans.
Employers who offer this benefit can give employees an interest-free or low-interest loan. When you receive a company loan, low-interest loans charge less than the benchmark interest rate.
According to the ATO, the term “loan” can cover a broad range of situations.
For example, imagine if an employee owes a debt to their employer. If that employer doesn’t enforce repayment when the debt is due, that unpaid amount becomes a loan.
Employers who offer fringe benefits, including loans, have to pay fringe benefits tax, or FBT.
Keep in mind, though, that interest rates may vary depending on how you use the loan. They may also depend on the income year.
In special cases, a private company may give debt forgiveness in the form of a debt waiver fringe benefit.
Loan Agreement: Setting the Ground Rules
A clear and comprehensive loan agreement is the foundation of any successful business loan arrangement. This document spells out the interest rate, repayment terms, fees, and any other conditions attached to the loan. It’s essential to review the loan agreement carefully to ensure it aligns with your business goals and current financial situation.
The agreement should specify whether the interest rate is fixed or variable, and reference the benchmark interest rate if applicable. This helps you anticipate how changes in the market might affect your repayments. Additionally, the loan agreement should outline what happens in the event of late payments or if the loan cannot be fully repaid, helping you avoid unintended debt forgiveness scenarios that could have tax consequences.
By setting clear ground rules from the outset, you can protect your business from misunderstandings and ensure that both parties are on the same page regarding repayment terms and obligations. A well-drafted loan agreement not only supports your financial health but also helps you stay compliant with tax law and avoid costly disputes down the line.
Loan Terms and Conditions
Every business loan comes with its own set of terms and conditions, which can significantly impact your company’s financial health. Key elements to consider include the loan term (how long you have to repay the loan), the interest rate (which affects the total cost of borrowing), and the available repayment options. For instance, a variable interest rate might be more suitable for businesses with fluctuating income, while a fixed rate offers predictability for those with stable cash flow.
It’s also important to consider how the loan will affect your tax return, as interest payments and certain fees may be deductible depending on your business structure and the purpose of the loan. Reviewing the loan terms and conditions in detail ensures that you understand your obligations and can plan accordingly. For example, some lenders may offer flexible repayment options, such as seasonal payments or balloon payments at the end of the loan term, which can help align repayments with your business’s income cycles.
By carefully evaluating the loan type, repayment options, and tax implications, you can select a financing solution that supports your business goals and maintains your company’s financial stability.
Interest Rates and Repayment
The interest rate on your business loan is a major factor in determining the overall cost of borrowing. Lenders may offer fixed or variable interest rates, each with its own advantages. Fixed interest rates provide certainty, making it easier to budget for repayments, while variable interest rates can fluctuate with market conditions, potentially lowering your costs if rates fall—but also increasing them if rates rise.
Repayment terms are equally important. You’ll need to decide between various repayment options, such as principal and interest repayments, which reduce your loan balance over time, or interest-only repayments, which can help manage cash flow in the short term. It’s crucial to monitor your loan account, keep track of outstanding invoices, and stay within your approved limit to avoid overextending your business finances.
By understanding the different interest rate types and repayment structures, you can choose the option that best fits your business’s financial situation. Timely repayments not only help you avoid additional fees and penalties but also support your business’s credit profile and long-term financial health. Always review your repayment terms and ensure they align with your cash flow and business objectives to keep your business on solid financial ground.
Should You Borrow Money Through a Company Loan?
Borrowing money through a business may be advantageous in many situations. But the rules that apply to these loans are equally strict.
As a director or owner, you need to be careful about completing a loan agreement and paying it back on time. These types of loans are typically for the advancement of the business and should not go towards personal or lifestyle expenses.
If you’re an employee, you may find that receiving a loan through your employer is one of the best financing options – especially in a tight lending market.
Employees who take advantage of a company loan may find that they can borrow money at a favourable interest rate. However, not all employers offer these types of benefits. And actual rates and repayments may vary depending on the employer.
If you’re looking for other financing options, Unsecured Finance Australia can help. Click here to find out more about short-term loans.
