Franking Credits - Strategies for Small Business Owners
A company is a legal entity in its own right so the money that a company earns is it's own rather than the Directors or Shareholders. Getting money out of a company must come in one of three ways.
The business owner is employed and is paid a wages
A loan is made
A Dividend is paid to the shareholders
Wages are well understood and are an expense to the business & an income to the recipient. They come with superannuation and worker's compensation obligations.
Loans – are taxable to the recipient. Funnily enough, the ATO doesn’t like this result and requires loans to be repaid with interest over a 7-year period.
Dividends – Where the company pays out the shareholders its profits (typically after-tax profits).
One of the most misunderstood and hard to explain concepts in accounting relates to Franking credits & what they are. Below we attempt to explain how they work & debunk a few myths.
Franking Credits Explained
Franking credits were introduced by the Keating government to stop double taxation of company profits. Simply, when a shareholder receives a dividend from a company, the dividend is paid from company profits. The company has paid tax on those profits prior to the dividend being paid.
The shareholder then needs to declare that dividend as income and is taxed again. The franking credit system gives a tax credit to the shareholder to avoid the income being taxed twice.
Essentially – this means that when the shareholder receives income from the company, they are taxed at their marginal rate on their share of the full company pre-tax profit and get a credit for what the tax the company paid.
How are franking credits created?
Franking credits get attached to fully franked dividends, which are generated by companies when they pay income tax to the government. When a company, big or small, makes a profit it is required to pay tax on that profit. Franking credits are created when the company pays that tax. These franking credits are essentially stored with the ATO until they are allocated to shareholders. For example, if a company (with less than $10m in turnover) makes a $30,000 profit it will need to pay tax of 25% tax (if is a base rate entity) or $7,500. When the tax is paid, this generates franking credits of $7,500. The company records these franking credits in a franking account. This will normally be maintained by their Accountant.
In the example above, the company would be left with $22,500 after paying the tax of $7500. Most small business owners will want to access this money. When they do this via a dividend, they get taxed on the full $30,000 at their marginal rate but then receive a credit for the $7,500. Depending on their marginal rate of tax, they may have to pay extra, top-up tax (to account for the difference between the franking rate of their marginal rate) or in the case of low-income earners, they may receive a refund.
There is a myth that a company tax result means lower overall tax. Whilst a company can offer a timing difference (which can be advantageous) when the funds are drawn down as dividends, the overall tax paid at the individual level works out the same (as if they had taken the funds as say wages) due to the franking system.
Strategies for small business owners
Family Trust as Shareholder
Dividends must be paid to shareholders in proportion to their shareholding. There may be circumstances where having a Family trust as a shareholder allows the ability to divert distributions to family members in a tax effective fashion.
Another approach to assist a business with asset protection is to have a shareholder of the trading entity as a separate holding company. A company can pay a franked dividend to a holding company. If at the same company tax rate, the tax payable in the recipient would be Nil due to the franking credit. This allows funds to be removed from the risky trading entity without the individuals having to pay any top up tax.
If you run your business through a company and your Accountant isn't speaking to you about franking credits, you may be paying more tax than you need to. Reach out to us and we can review your structure to ensure that you have the appropriate tax minimistation strategies in place.