It is a frequent practice among entrepreneurs to invest their own financial resources into their startup to fuel its launch and maintain operations until it becomes self-sufficient. A recent legal case has cast a spotlight on the risks associated with extracting funds from a business without giving due attention to potential tax consequences.
In a recent case presented to the Administrative Appeals Tribunal (AAT), a taxpayer faced a setback due to the indistinct separation between his personal expenditures and the expenses of his business.
The individual in question was both a shareholder and director of a private enterprise. During several years, he made a series of withdrawals for personal use from the business’s bank account, which were not declared as taxable income.
Upon review, the Australian Taxation Office (ATO) determined that these withdrawals should be taxed either as:
• Assessable income belonging to the taxpayer, or
• Presumed dividends pursuant to Division 7A provisions.
Division 7A is designed to address scenarios in which private companies distribute benefits to shareholders or their associates through loans, payments, or debt forgiveness. When Division 7A applies, the benefits’ recipient is deemed to have received an unfranked dividend for tax purposes.
The taxpayer contended before the AAT that these withdrawals were in fact repayments of loans he had initially made to the business, arguing they should not be taxable as income. In another argument, he maintained that these were loans to himself and should not be considered dividends as accorded by Division 7A, because the company lacked a “distributable surplus”—a specific term which caps the deemed dividend according to Division 7A.
The AAT, however, identified shortcomings in the taxpayer’s documentation, finding that he was unable to demonstrate the ATO’s assessment was too high. The AAT’s decision was influenced by various factors: • The taxpayer presented multiple versions of his financial records and tax filings. • He was unable to convincingly account for the source of the funds used for the original loans to the company, particularly as he had reported tax losses in several years coinciding with the time the loans were issued.
Although the taxpayer suggested that some of the funds for the company had been borrowed from his brother, the AAT found this claim doubtful, considering the brother’s tax returns indicated only a modest income.
How should a business owner’s financial input to launch a business be processed? The answer varies with each circumstance, but for smaller ventures, typical strategies include: • Formulating the investment as a loan to the company, or • Opting for the issuance of shares by the company, with the invested sum treated as share capital.
Deciding the most suitable method involves considering various factors, including business concerns, the future extraction of funds from the company, and compliance with legal stipulations.
The method chosen to inject capital into a company also shapes the routes available to retrieve those funds later. The critical point to bear in mind is that the withdrawal of funds from a company will often invoke tax implications that must be judiciously managed.
