What our Politicians Don’t Seem to Know about Small Business Tax Cuts

This was written in early 2016 when the government was trying to buy votes for the election with random, ill thought out announcements. I never finished it to a point that I was really happy, but the underlying thoughts are still valid.


Once again, I feel compelled to write my thoughts regarding something our politicians are promoting.

This hyping of tax cuts for small business is extremely annoying as, at best, it is increasingly apparent that our politicians really don’t understand the real world and, at worst, the politicians are engaging in “Econobabble” (reference Richard Denniss’ book) and actively trying to mislead (or dare I say deceive) the voters.

Here are some key comments:

  • Firstly, they are not tax cuts for small business – they are tax cuts for small companies with annual turnover of less than $2 million (https://www.ato.gov.au/General/New-legislation/In-detail/Direct-taxes/Income-tax-for-businesses/Small-Business—tax-cuts-for-small-business/) (Note that even the ATO website attempts to mislead by using “Small Business” in the page title)
  • Partnerships, sole traders and trusts are not included
  • Tax is calculated on net profit.  Wages, salaries, superannuation, rent, equipment leases, office expenses, staff training, telephone, internet, etc are paid for BEFORE tax is calculated (see examples later).  As such, reducing the tax rate has absolutely no effect on wages – it doesn’t give the business the opportunity to pay a higher wage to staff
  • Basic financial planning says that you don’t build your wealth in your trading entity.  What that means is that most small business owners want to move profit from the small business to a trust or personal investment structure
  • A small company that has made a profit and paid tax, then has a tax credit in it’s “franking account” with the tax office.  Those “franking credits” can then be paid as part of a dividend when the profit is paid out of the business.  This means that tax paid by a company is only partially kept by the government – it often has to be paid back to the dividend recipient in later years!!
  • As with everything, there is no one answer
    • My conclusions within this document will not apply to 100% of businesses 100% of the time
    • Some business owners like to build cash and franking credits within the business as they increase the value of the business when it is sold.  However, business owners that do this would normally have their personal finances well under control
    • Most small business owners that I know need to take the profit in order to cover their personal expenses

Note that in the following examples, it is assumed the owner is taking a “normal” salary and not taking profit in the form of a higher salary or any other means for extracting profit from the business without it showing as profit.

Some notes about the calculations in the following examples:

Turnover$1,000,000$1,000,000$1,000,000
Expenses (salaries, rent, office, leases,etc)$500,000$900,000$1,000,000
Net Profit$500,000$100,000$0

Tax @ 30%$150,000$30,000$0
Tax @ 28.5%$142,500$28,500$0
$7,500Net Benefit to Business$7,500$1,500$0

In none of these cases, is the amount left in the business sufficient to buy equipment that is not normally deductible (i.e. goods over $20,000 can’t be deducted as expenses at present, so purchase of a car or other equipment requires significant capital, or a loan).  However, in many cases, businesses lease these items so they are fully deductible as expenses anyway.

Even when the ability to immediately write off purchases of up to $20,000 returns to normal ($1,000) at the end of the 2016/2017 financial year, the $7,500 saved by the business that made $500,000 in profit is laughable.  If the business is making $500,000 in profit, then the $7,500 is meaningless from a business growth perspective.

Lets follow a few options for the highly profitable business to pay out it’s profit.

Scenario 1 – 30% Company Tax, profit paid as a dividend

Scenario 2 – 28.5% Company Tax rate

Highly profitable business comparison

  • Structuring is much more important than tax rate
  • Reducing the company tax rate:
    • actually increases the tax payable by the owner who doesn’t make use of structuring
    • marginally ($1293) reduces the tax refund payable by the tax office
  • For a business like this, reducing the company tax rate actually raises more tax!

Lets try it again for the somewhat profitable business

Scenario 1 – 30% Company Tax, profit paid as a dividend

Scenario 2 – 28.5% Company Tax rate

Somewhat profitable business comparison

  • Reducing the company tax rate:
    • actually increases the tax payable by the owner who doesn’t make use of structuring
    • marginally ($208) reduces the tax refund payable by the tax office
  • For a business like this, reducing the company tax rate actually raises more tax!

Conclusions

  • Structuring is much more important than tax rate
  • Treating small business on a year by year basis is not particularly fair, because, by the time a small business starts to make a profit, there are often a number of years where the owners of the small business have made no profit and, in many cases, have under earned during the startup years.