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Making the decision to go into business for yourself is scary enough as it is, but once you’ve decided to do so, there are some pitfalls to be aware of. Specifically, the biggest one to address as a new business owner is the income tax you’ll need to pay at the end of the financial year.
Back in the days of being an employee, if you earnt $1000 / week, you would have received $817 in your bank account. This is the amount you would have had to work your household budget on. While this may have been a struggle at times, at the least you wouldn’t have owed anything to the ATO come the end of financial year – and may perhaps even got a refund from them!
This changes when you’re running your own business.
One benefit of running your own business is being able to charge your time at a much higher rate than what you would have been paid as an employee. For instance, let’s say you now charge $60 / hour, so working a 38 hour week, you’re now earning $2,280. There will likely be some overheads that are built into your labour cost regardless of what occupation you’re in – for instance, stationary, office, or vehicle costs - so let’s say this accounts for $280 / week. This leaves you with $2,000 / week after expenses.
‘Yahoo!’ you think! ‘That’s the way to go!’
Then the clincher happens. Come June 30th, you lodge your tax return and receive a bill of $28,236.00. What - how’d that happen?
Well, did you provide for it? No, you’ve spent it forgetting about the fact that your income throughout the year was subject to income tax.
I’ve seen this happen in the first year of many new businesses. There is rarely a tax provision made, as at that stage, the ATO is unaware your income tax has not been provided for.
After the first year, once the tax return has been lodged and you receive a bill, you’ll then have an amount added to each BAS (if registered for GST), or you’ll receive an IAS. This is the ATO’s way of putting you in the system; making sure you’re providing for the tax bill come end of year.
Your first year of business is where you need to do some planning ahead. Prior to you having an amount charged by the ATO for your Pay As You Go Income (PAYGI) tax, you’ll need to provide for this so you don’t get caught short.
Putting it on the back burner and dealing with it when it happens is short sighted and one of the main pitfalls that sole traders/partnerships and even companies encounter that then causes them to go out of business.
Not only will you then have an ATO debt for the previous year’s income to cover, but you will also have to start providing for the next year’s income tax bill. All that ‘extra’ spending money you earned from working for yourself is then going to come back to haunt you!
Starting a GST Provision / Income Tax Provision Account
This is precisely why many banks advise that business owners start a GST provision account. The reasoning behind this is that you ensure you’re putting money aside specifically for no other reason than paying your BAS. That is, if you receive $1,100 from your client, $100 (if registered for GST) goes into your GST provision account.
It helps to remind yourself that this is not, and has never been your money – you received it solely so you could send it off to the ATO later.
What the banks should also be telling you is that this GST provision account should also be called an Income Tax provision account, and whatever tax amount is payable on your income should be put aside into this account as well.
Calculating your income tax to date can be done on a weekly, monthly, or quarterly basis.
I usually advise my clients that they should set aside 30% (if GST registered) or 20% (if not) off the amount they receive from their customers to put into their provision account. The remaining amount should then be used for their household budgeting.
Every three months, they can then have a look at their profit and loss statement and assess whether their tax provision is sufficient.
Calculating for a sole trader
If you’re a sole trader, you just need to divide the profit-to-date by the number of weeks (to get a weekly wage). Enter this into the ATO tax calculator and then multiply the weekly tax calculated by the number of weeks.
For instance, one of my clients (we’ll call him John) runs his own business and is not GST registered. At the end of December, he received $59,280 of income (disregarding expenses). John put away $11,856 for income tax (20% of what he’d received). If his P & L shows business expenses of $7,280, then his net income is only $52,000 for the period. This means he will be under provided by only $2,262 for the six month period (tax being $543 per week).
At this stage, John can then put an extra amount into his provision account and increase the percentage he takes off each payment in the future. If he doesn’t, he knows he can expect a bill come end of financial year. Whatever decision he makes, he is at the least keeping himself informed of what is going to happen – instead of having a bill of $28,236 at the end of the year, the worst-case scenario is that he only has a bill of $4,524 (which I think we can all agree is significantly more manageable)!
Calculating for a partnership
If you are a partnership, the percentage for tax provision can change, as both parties can take advantage of the tax-free threshold of $18,512. In this case, a net income of $104,000 split between two partners who don’t have any other income or job would be $52,000 each. This also relates to Family Trusts, where the income may be split between two beneficiaries or more, when children come into play.
As an example, let’s say Jane and Peter run a business together. Both would have a tax bill of $9,516 at the end of the year, or a total of $19,032. Assuming Jane and Peter followed the suggestion of putting away 20% from every payment, they would have an overprovision (or refund) amount of $4,680 at the end of the year – lucky them!
Calculating for a company
If you’re running a company, then you should be providing tax at the applicable company tax rate which is dependent on your annual threshold and the income tax year. Providing at this applicable tax rate without considering any depreciation / amortisation should ensure you have sufficient provision to meet your tax bill.
Summing it up
Ultimately, it’s advisable that you do keep checking your P & L periodically to ensure your provision is sufficient. This applies even after you’ve lodged your first tax return for the business and the ATO has provided you with a PAYGI rate / amount to pay.
Given the range of tax concession benefits available for small businesses, you’ll find yourself able to write off large amounts in your first year. Unfortunately, however, it’s also quite easy to find yourself short in the following year when you have nothing left to write off and you’ve just been using the percentage rate provided by the ATO based off the previous year’s figures when you had a lot of expenses. In this case, you’ll find yourself behind the eight ball once again!
Julie Carter AIPA, BBus(Acctg),
MYOB Professional Partner, Registered BAS Service Provider
Associate Member of Institute of Public Accountants
Member Association of Accounting Technicians
ph: 0417 927 654 email: firstname.lastname@example.org
Accurate Books Always (Servicing from Leederville to Pinjarra, Fremantle to Armadale WA)
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