You made a profit but you have no cash in the bank! How does that work? I get this question at least once a week. The other statement I regularly hear is that the business owner feels like all he does is pay tax and never gets ahead. By the way, we all feel like that sometimes: we pay tax, and every time we get cash in the bank, we have to pay tax and out it goes. If this sounds like you, then you are going to get a lot out of this extract. There is a way to plan for the timing and amount of tax payable.
One of the biggest frustrations that send businesses to the wall is misunderstanding the timing and amount of tax payable. The reason being is that it is an obligation that sneaks up on most businesses. Tax is paid on the profit of the business. If the business is set up as a company, then up to 30% of the profit is payable in tax. Now tax is really just another expense of the business. So why does it cause business so many issues? Largely, it is due to the tax not being payable immediately when profit is earned. Tax may not be payable for up to twenty-one months after a business commences or at minimum nine months after the end of the financial year when the profit is calculated. The time lag is the thing that causes the issue. But really the issue is that the business owner is not making a provision and budgeting for the tax.
There is also a massive sting in the tail for new businesses and businesses that are experiencing significant growth and expansion (I call it the tax double whammy). Let me explain by way of example.
Let’s say there’s a business set up as a corporate structure that in its first year, makes a profit of $100,000. Whilst we can estimate what the profit will be prior to the end of the year, we need to complete the year before we determine the actual profit. In Australia, the financial year runs from 1 July to 30 June. So as of 30 June, the actual profit for this company is $100,000. The tax payable will be up to $30,000. If the company lodges its own tax return, it will be due by 31 October in that year. However, if the company engages a tax agent to lodge the income tax return, it may not be due for lodgement until March of the following calendar year—that is, nine months after the end of the financial year. This on the face of it seems fantastic because businesses get to retain those funds for longer, which is true. However, if this money has not been set aside or budgeted for, then I find that most businesses have spent the money on growing the business further and don’t have the funds available to pay the ATO when it is due. Can you see the big issue arising here?
Another issue is the PAYG Instalment system. The company can lodge its tax return anytime from July until March of the following year. Generally, most businesses don’t lodge their first tax return until as late as possible. Once the return is lodged, the ATO then makes an assumption that the profit earned in the previous financial year will be earned again in the current financial year and will issue a PAYG Instalment notice requesting the company to pay approximately the full amount of tax as the previous year, in this example, $30,000. (Note the ATO will apply a CPI increase to the previous year.) Normally, the obligation of the company is to pay this quarterly; however, because this is the catch up of the first three-quarters of the financial year, the ATO can levy a full year in June. This results in a further $30,000 of tax being due and payable in July. For the business owner, this means that you will need to pay two years’ tax in the space of four months. Ouch. Can you see how important that budgeting is now?
When you lodge your tax return for the second year, this tax paid is a credit against the tax payable on the profit. So if your second year of trading had the same profit as your first ($100,000), then there will be no further tax to pay. However, if the business has increased the profit for the year, for example, to $150,000, then there will be tax payable of $15,000 when the company lodges its income tax return ($45,000 tax less $30,000 PAYG Instalment) to allow for the increased income. This can be the make or break in the cash flow for the business.
There is an ability to vary the amount of tax levied on your BAS if you estimate your profit will be less in the current financial year as compared to the previous year. However, if the profit is more, there is an obligation to pay an increased amount. (Note: It is not a recommended strategy to decrease your estimated profit, as you will need to make payment one way or the other. Again, seek professional specialist advice before you take action.)
Then on your September BAS, you will be obligated to pay approximately $7,500 per quarter for that current year’s tax, that is, the third year of trading.
All of these tax payments should be included in your cash flow forecast. Some accountants will budget for them in the profit and loss, but most will include them in the cash flow forecast as part of the balance sheet liabilities. I am not fussed whether you include them in your budget profit and loss and then your cash flow forecast or just your cash flow forecast, as long as you do it.
Everyone hates surprise bills, even small ones, but tax is usually a large bill, which makes it worse. To reduce any risk of surprises, for some of our Virtual CFO customers that require constant cashflow analysis we project 12 months of tax liabilities for our business owners, so there are no surprises. We update this forecast every month based on the projected profit of the business. While we may not be 100% correct, we are at least keeping the business owners aware of their obligations so they don’t spend the cash before considering their future tax obligations.
If you’re interested please send me an email at firstname.lastname@example.org and we can discuss how I am able to help you or your business’s success.