Directors’ loans and why they’re a problem

Has your accountant ever spoken to you about ‘Division 7A’ loans and now for some reason you’ve got extra tax bills, dividends and a whole lot of confusion? You’re not alone. It’s a common problem for a lot of businesses that operate with a company in their structure. While it’s common, it’s not very well understood by business owners and that’s partly because it’s complicated but it’s also because we, as accountants, like to use terms like ‘Division 7A’ which means pretty much nothing to anyone that doesn’t work in the industry.

In this article we’re going to explain the complications that arise when you take money from your company and how you can avoid the dreaded ‘Division 7A’ loan.

If you run a business through a company or have a bucket company in your structure, read on. If you’re a sole trader or trust then the below won’t be relevant to you but could be some good bedtime reading if you’re having trouble sleeping.

Most business owners think about the cash of their business as their own money and spend it accordingly. While this is true for a lot of people, this mindset of thinking about everything as being yours is dangerous for businesses that operate with a company in their structure (whether that be a trading entity or a bucket company).

A few people will be a bit confused at this point because after all, it is your business so why isn’t it your cash? Legally, and for tax purposes, a company is a separate entity from the owners. It’s basically treated as if it’s a separate person.

Here’s one way to think about it. Assume the company is a friend of yours who is out there operating a business and making money. If you had access to their bank account and started transferring yourself money or spending their cash on your personal expenses they’re likely going to have some issues with this. And that’s probably fair enough, after all, why are you entitled to their money? You didn’t earn it!

That’s how you should think about your business. It’s the company’s money not yours.

The issues arise where a company has cash and the business owner treats this as their personal money and takes it out of the business or spends it on personal expenses. The consequence of this is that the business owner ends up owing the company money.

The reason that owing your company money is a problem is complex but we’ll try explain it in a simple way.

Basically, the issue is that companies pay tax at a fixed rate of 25% for small businesses but individuals pay tax at potentially higher rates up to 47%. The government doesn’t want you to spend the company’s money as if it’s yours while capping the tax at 25%.

Let’s take an example. Assume your business makes $500k profit for the year. Here’s what the tax would look like if it was a company vs individual:

As you can see, the company pays a lot less tax and that’s fundamentally the issue. What the government is saying is that you can’t treat the money as being yours (i.e. by spending it on personal expenses or transferring to your personal bank account) without treating it as your income and paying tax on it.

A loan arises where you owe your company money. This is where the term ‘Division 7A loan’ comes in. The reason it’s called ‘Division 7A’ is because that’s the division of the tax act where the rules are. It’s a stupid name to use really because not everyone is reading the tax law like we do. For this article we’re going to refer to the loans as ‘director loans’.

The rules are pretty prescriptive when a director’s loan arises and requires you to do something about this loan. The options are:

In our experience, most business owners who have taken cash from the company have spent it and aren’t in a position to repay the loan. As a result, most people will enter a loan agreement and make the repayments over 7 years. The repayments are usually made by the company declaring a dividend but instead of paying it to the shareholder, the amount is offset against the loan thereby meeting the minimum repayment for that year.

The first, and most obvious option is to not take the money from the company. However, you, as the business owner still need to get paid so here are two options to access the company cash without causing an issue: