Many factors contribute to a small businesss achieving success. One of the most vital is managing cash flow. An area where businesses get into trouble is not anticipating infrequent annual costs such as rates and insurance. Another that causes major headaches is income tax.

Q. I have been running my business for three years but only made enough money last year to have to pay income tax. I have now received a letter from the ATO saying I will be paying Pay As You Go instalments tax. What is this and is it an extra tax?

A. The PAYG instalments tax advice you received from the ATO is purely a courtesy letter to let you know you are now caught up in this system. PAYG instalments are not an extra tax and, prior to the introduction of the GST system in 2000, PAYG instalments were called provisional tax.

This instalment tax system was introduced to bring the cash flow of people earning business and investment income more into line with those who receive salaries and wages. Employment income has tax deducted every time it is paid. When you receive business or investment income you do not pay tax until after you have lodged the applicable tax return.

To try and create a more level playing field, and to make sure the government received its cash flow more evenly during the year rather than in lump sums, the PAYG instalment tax system was introduced.

Once a person earns more than $2000 in either business or investment income in a year, and the amount of income tax payable is more than $500, you can be caught by the PAYG instalment system. One of the few exceptions will be if a taxpayer is entitled to receive the seniors and pensioners tax offset.

Based on the income tax return lodged that resulted in tax payable, the ATO applies an uplift factor of 4 per cent to arrive at an estimated tax payable amount for the next year. Where this estimated income tax is less than $8000 the PAYG instalment can be paid as one annual lump sum by October 21 each year. Where the estimated tax is greater than $8000 the PAYG instalments are paid quarterly.

You don't have to do anything until the ATO notifies you of how much your first instalment will be and the payment date. If there has been a significant change in your business, which means you will not be as profitable as the year the PAYG instalment has been based on, you can reduce the PAYG instalment. Care must be taken when varying an instalment as penalties are imposed if you underestimate the final amount of tax payable.

Anyone starting a business should plan for the fact that tax will eventually be payable on profits made. Depending on the type of business you run, and the net profit percentage of your turnover, amounts of anywhere between 5 per cent up to 30 per cent of money received should be put aside in a bank account to meet future income tax liabilities.

Questions on small business tax or other issues can be emailed to business@taxbiz.com.au. Tax for small business, a survival guide, by Max Newnham is available in bookstores and as an ebook.