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.
Read more about borrowing money from a business to find out if this is the right option for you.
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.
There are two different types of loans available to individuals. They are:
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 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 and interest charge. 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.
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.
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.
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.
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.
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.