Super tax refund strategy - how to get a refund of tax paid by your company
When business clients sell their business and retire, we mistakenly assume that there will be no need to make any further deductible (concessional) contributions to the super fund on behalf of directors.
This article considers how to get tax refunds for clients well after they have retired. This strategy is best explained with Sam's Story.
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Sam's Story
Sam, a locksmith was running his business via a company for 20 years till he reached 55 years old and retired in financial year ended 30th June 2010. In the past 20 years, his company paid him wages and contributed to his Self Managed Superannuation fund. At the time of retirement, the company had gross $500,000 retained profit after tax of $150,000 (30% franking credit) and cash of $350,000. His self managed super fund had a balance of $500,000. Since there is no home loan, he reckons, he can live on $600 cash per week.
Since the company is earning 6% interest on $350,000 cash, Sam is worried that he will have to pay tax for the rest of his life. If he withdraws this money and makes a non-concessional contribution to his SMSF, he may have to pay tax if it is paid as a franked dividend as his income will go over $80,000 where the marginal tax rate is higher than 30% imputation credit.
He can take a loan from the company and make a non-concessional contribution but the interest paid under Div 7A will not be deductible. We consider three other options for him.
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Option 1: Pay directors fees to Sam
Since the $350,000 is invested to earn $21,000, all of that can be paid as directors fees each year to Sam, so that the company does not have to pay any tax at company tax rate. Since he is 55 years old, Sam can also commence a pension from his SMSF where he has to be paid minimum of $10,000 ($500,000 times 2%) income stream.
This income stream is entitled to 15% pension rebate and after low income rebate; Sam will be required to pay less than $940 in tax. This will leave about $30,000 income or $600 per week which he wants for his running expenses.
Net Cash flow
|
|
Company |
SMSF |
Individual |
|
Opening Balance |
350,000 |
500,000 |
|
|
Pension Payment |
|
-10,000 |
10,000 |
|
Company Income |
21,000 |
|
|
|
Directors fees |
-21,000 |
|
21,000 |
|
Tax to pay |
|
|
-940 |
|
Closing Balance |
350,000 |
490,000 |
30,060 |
|
Net Cash Balance |
$870,060 |
|
|
There is nothing wrong with this strategy, however each year SMSF balance is reducing and company still has substantial amount in cash. We note that this is the most common strategy.
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Option 2: Pay company tax and dividends to Sam
This strategy is a bit clever and instead of paying directors fees to Sam, we decide to pay Dividends and pay tax on company income.
If $14,700 cash is paid with imputation credit of $6,300, along with $10,000 income stream from the SMSF, Sam's taxable income is $31,000 and with pension rebate and low income rebate, Sam ends up paying net tax of $940 as in option 1.
Under this option, the company's cash position remains the same as it has to pay company tax of $6,300 (30% tax on $21,000 interest income - imputation credit available for distribution in later years) and dividend of $14,700, this cash payment however gets replenished by $14,700 after tax interest income.
Sam's cash flow is $10,000 income stream from SMSF plus $14,700 cash dividends plus a tax refund of $5,360 or about $30,000 which is required for his living expenses.
Net Cash flow
|
|
Company |
SMSF |
Individual |
|
Opening Balance |
350,000 |
500,000 |
|
|
Pension Payment |
|
-10,000 |
10,000 |
|
Company Income |
21,000 |
|
|
|
Tax to pay |
-6,300 |
|
-940 |
|
Imputation Credit |
|
|
6,300 |
|
Dividend Payment |
-14,700 |
|
14,700 |
|
Closing Balance |
350,000 |
490,000 |
30,060 |
|
Net Cash Balance |
$870,060 |
|
|
Again this strategy is a bit better than option 1 as we able to get a refund each year but adding more to the franking credit each year and the SMSF balance is again reducing each year.
Option 3 Pay tax, dividends and maximum super contributions
Since Sam is over 50 years, he can contribute $50,000 as concessional contributions in financial year ended 30th June 2011. In this option, the company pays a cash dividend to Sam of $49,700 with imputation credit of $21,300 and pays tax on its interest income.
With minimum income stream of $10,000 and $50,000 tax deduction for superannuation contributions, Sam's taxable income remains at $31,000 and with pension rebate and low income rebate, Sam will pay tax of only $940 similar to option 1 & 2 but due to imputation credit will get a net refund of $20,360.
With $9,700 left from pension payment after paying $50,000 contribution to super Sam will be left net cash of $30,060 including the tax refund which is similar to option 1 and 2. Note that under this option 15% tax will be payable by the SMSF for concessional contributions, but due to refund of imputation credit the net assets is higher by $7,500 more than option 1 and 2.
Net Cash flow
|
|
Company |
SMSF |
Individual |
|
Opening Balance |
350,000 |
500,000 |
|
|
Pension Payment |
|
-10,000 |
10,000 |
|
Company Income |
21,000 |
|
|
|
Super Contribution |
|
50,000 |
-50,000 |
|
Tax to pay |
-6,300 |
-7,500 |
-940 |
|
Imputation Credit refunded by ATO |
|
|
21,300 |
|
Dividend Payment |
-49,700 |
|
49,700 |
|
|
|
|
|
|
Closing Balance |
315,000 |
532,500 |
30,060 |
|
Net Cash Balance |
$877,560 |
|
|
Conclusion
By contributing maximum into Self Managed Super Fund under option 3, Sam has two major benefits. Firstly he is able to empty the company's cash box which means that each year company will earn less interest income and secondly by moving the assets into self managed super fund, the SMSF can earn tax free income in future years and once he is 60 years old, he can receive tax free income streams from the SMSF at individual level.
There are some important issues which the advisor must consider before implementing this strategy, such as,
Ø It is possible that concessional contributions may be reduced to $25,000 in future years which means that it will take longer to empty the franking credits
Ø Government may decide not to half the minimum income stream withdrawal limits from the current 4% to 2% for pensioners below 65 years old. That means dividends may have to be reduced in future years. However, those who are over 60 years need not to worry about this issue as any pension withdrawn is considered as exempt income and not included in taxable income. Sam can be paid higher dividends when he gets older than 60 years.
Ø This strategy cannot work for personal services Income Company, where all the income must be paid to the income earner as wages.
The strategy where business owners withdraw large amounts of profit of the company as salaries should be questioned as with cash box strategy combined with superannuation contributions strategy; it is possible to keep the company's effective tax rate as low as 15% due to 15% tax refund after retirement or when directors have no other income.
This means that any salaries paid to business owner above $37,000 should be avoided as individual tax rate of 30% kicks in after that level. If there is a mum and dad situation, a couple can get $66,770 per year cash after tax or $1284 per week.
Logic for withdrawing higher salary is usually to reduce non-deductible home loan. With interest rates hovering around 7%, it can be cheaper to be on interest only loan then to pay 15% higher tax. But most of us have this expensive Australian dream of owning our own home, which only helps ATO in higher tax and banks to earn Billion dollar profits as the loan returned to them is lent to someone else.
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Sent by :-
Manoj Abichandani SSA SSAud
SMSF Specialist Advisor
SMSF Specialist Auditor
Team Leader
