The myth about the way most businesses are taxed
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The myth about the way most businesses are taxed

There is often a misconception among new business owners that they are taxed on the money they withdraw from their business. For nearly every business entity structure this is not the case, the only exception is when a business is operated through a company.

Paying for dry cleaning is an issue.

Paying for dry cleaning is an issue.

Photo: Stocksy

When a business is operated through a company, and cash is withdrawn by the shareholder owners, this can result in the withdrawals being classed as income of either fully franked or unfranked dividends.

For the other business structures, including sole traders, partnerships of individuals, family discretionary trusts, and unit trusts, the owners of the business are taxed on their share of the net profit made by the business.

Q. I work for a designer business that is run by a sole trader. The owner will not withdraw money from her business account as for some reason she believes she is heavily taxed each time she withdraws money. She frequently travels overseas and I have asked for an amount of cash to pay for work expenses such as her dry cleaning, taxi etc. She instead reimburses me for these expenses which sometimes leaves me out of pocket for some time and can create cash flow problems for me. Can she do this and is she correct about being taxed on money she withdraws?

A. There is no legal reason that would stop the owner of the business reimbursing you for the expenses you are paying; it will be up to you decide whether you want to continue working for someone who does this. A more practical way of dealing with these types of expenses is to set up a simple petty cash system.

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Under this system a cash float is established, such as $200, and the small business expenses are paid from this float. As each amount is paid it is recorded with the tax receipts kept to justify the amount spent. Periodically an amount of cash is withdrawn to bring the float up to the cash float balance, with the reimbursement being allocated across the different expenses paid out of petty cash.

Your employer is wrong about her paying tax on amounts she withdraws from the business as a sole trader. She will only pay tax on the net profit that her designing business generates each financial year. This net profit is calculated by reducing the taxable business income by all allowable tax deductions.

When businesses are started losses or very small net profits are produced. For sole traders losses are either carried forward or, if they pass the non-commercial loss tests, they can reduce their other income. If a profit is made this is added to other taxable income they have earned in a financial year, and they pay income tax on their total taxable income.

In many cases small businesses need to borrow money to help fund the set-up of the business, the business activities when insufficient income is produced, and to provide cash flow for the owner’s living expenses. In this situation the cash withdrawals are clearly profit as they are funded from the borrowing.

Max Newnham is a partner in TaxBiz Australia and founder of SMSF Survival Centre. Email questions to max@taxbiz.com.au.

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