There is so much misconception in Australia about taxes and tax planning. Everyone seems to think they're "paying too much" and believe that accountants can wave a magic wand and "save" you tax.
So if you're ready for the cold hard truth, watch this;
Hey team, Nathan Watt from Watson & Watt.
Today we are talking about the truth about tax planning. Is it my truth? Is it your truth? Is it your mate's accountant's truth? I don't know. Is it true that accountants have magic wands that we wave over the books and make your taxes disappear? Uh, no.
So there's a few things I want to run through, lots of misconceptions around how taxes work, how deductions work, how we can "save" tax.
What does "saving" actually mean?
And some tips and traps to watch out for so let's get into it.
- You don't want to pay less tax (I'm going to expand on that in a minute)
- Putting tax in perspective
- How do taxes work (in 30 seconds so we don't get bored to death)
- Most tax strategies don't "save" tax
And then some bonus stuff at the end there some ideas for you to consider
So let's have a look at it. Now the first one is;
You don't want to pay less tax
You might say, that's rubbish Nathan, of course I want to pay less tax. But I would suggest you actually want more cash. I don't pay for my groceries with taxes. I pay for my groceries with cash. So if you look at this simple example here. An individual can either pay $0 in tax or $55,000 in tax. I know which one I want, I'm going to pay the $55k in tax every day of the year if I can get $106,000 more cash in my pocket.
Put it another way, if somebody offered you $1,000,000, but you have to pay $500,000 in tax or they could give you $400,000 and you only pay $100,000 in tax - I know which one I'm taking. I'm talking the million dollars every day of the week and paying half a million in tax because I get more cash. It's that simple. So stop worrying about your taxes, worry about what you are doing with the cash.
Now let's put tax in perspective.
This is a business with $1mil in sales, cost of goods sold of $400,000, gross profit of $600,000 all the way down to a $200,000 profit, which is a 20% profit margin which is pretty healthy. Now let's look at this. If it's in a company, it's going to pay tax at 25%. It's going to pay tax of $50,000.
If it was a sole trader or whatever other reason you've got a 47% tax rate, you'd pay $94,000 in tax. But that's only 9.4% of your sales. So what are you doing with the other $906,000?
That's the more important question.
Can you save some tax off $94,000? Maybe.
You might get it down to $90,000, you might get it down to $80,000 - I don't know. Is it going to be $0? No.
Is it going to be half that? No.
So what you need to be looking at is where am I spending the other $906,000 in my life? And let's look at how we can change that stuff. You'll get way more cash in your pocket because of the way the tax system work.
So if you look at your taxes as just another cost of doing business and just another expense in your life, and you look at it as a percentage of your revenue, it's actually not that big of a deal.
The big deal is that people get surprised by it and they have to pay big lumpy amounts, and they're like OMG, I have to pay $50,000 worth of tax - I haven't saved for it. That's the problem.
It's not the amount of tax - it's that you haven't saved for it, and that you spent the tax money on something else.
How does the tax system work?
Same example as before, one has income of $18,000, and one has $180,000. Contrasting the two you get more cash if you earn $180,000 than if you earn $18,000.
what is income?
That's a long and boring story, so let's just call it your revenue, and what are expenses well they're called tax deductions, but that's another long and boring story. So essentially it's your income less your expenses equals profit. Think of that as your taxable income. Am Am I oversimplifying things? Yes. But if you just think of it like that we'll get through this a bit easier.
So your profit is what you pay tax on, if you have $18,000 of revenue, and spend $10,000 on stuff you have taxable income of $8,000. You don't pay tax on $8k as an individual (if that is your only income). Which means you have after tax cash of $8,000. Not a whole lot of money to live on.
Contrast that to someone who's got $180,000 of income and they've got $10,000 of expenses, they have $170,000 left over, they pay $51,367 in tax on that at current tax rates. Which is less than in the previous example.
They're not paying $10,000 less, it is only $3,900 less. Why?
1. Because we have a marginal tax rate system so it's not dollar for dollar refund. You don't spend $10,000 and the tax office gives you $10k off your tax back. That's not how it works. Your deductions are as only as good as your tax rate. In this case the rate is 39%.
So for the person on $18k, they spend $10k and pay $0 in tax meaning they are out of pocket $10k.
The person on $180k, they spend $10k, and it only costs them $6,100, because the tax office is going to reduce their bill by $3,900. BUT you are still out of pocket $6,9000. So if you don't need to spend the $10k, don't spend it because you can't spend your way out of a tax bill.
Do Companies save tax?
Sort of. No. They actually defer tax. So let's have a look.
Again a sole trader makes $180,000 of income with an ABN in their own name selling widgets and they pay their tax. They have have $124,000 after tax cash and they go and live their life and buy groceries and beer and skittles and all sorts of stuff. There's no additional taxes because the sole trader is the same person as an individual taxpayer for both tax and legal purposes.
Now if this business was in a company, a Pty Ltd. It has $180,000 of profit, it would tax of $45,000, which is 25% and hey look at that we'll save you $10,000 in tax and aren't we so smart you should pay us lots of money because we're the best accountants ever. But you as the individual still need to buy beer and skittles, so how are you going to do that if you leave it all in the company?
Well you need to pay a dividend or you need to pay wages. I've used the dividend example because it makes these calculations easier and consistent and I can cut and paste, but the important thing here is whether it's wages or dividends doesn't matter for tax purposes because the end result will be the same.
So you have $135,000 after the company pays its tax. You rip all that out to go and buy beer and skittles. In your personal tax return you get the $135,000 dividend then we add on the tax that the company's already paid to put the individual back in the same position as the company was so there is no double taxation. The individual then calculates tax at their marginal tax rate which works out to be $55,267 and then you get a credit for the tax the company has already paid which means Mr & Mrs shareholder have to pay $10,267 out of the $135,000 they have already received. So look at that the after subtracting that, the after tax cash is exactly the same - it's just whose pocket has paid it.
In this one, the company pays $45k of it, and the other $10k from the individuals. In the sole trader they just pay all $55k. So it doesn't matter, the tax is exactly the same and that is why company's don't save that, they defer it.
Leaving Cash/Profit in the company
What happens if you don't pull that profit out and you leave it in the company and you go and buy more stock, more equipment, invest in all sorts of stuff and build the business?
Well when you shut the business down, when you sell it or if you die, whoever is left needs to get these retained profits - which is the accumulation of all your profits over time. That needs to come out of the company at some stage, so somebody is going to have this calculation into their tax return. So at best you're deferring tax and you're making it somebody else's problem.
Most Strategies don't save tax - they defer it
Alot of the tax strategies being peddled around don't actually save tax, they defer it. There might be claims that we've saved so and so $x amount of dollars. Is that true? Maybe. It might have saved it this year, but did it save it for next year or did it just bring forward what you would have already got or kicked the can down the road?
I don't think deferring tax is actually saving tax. It's just creating a problem for tomorrow and a lot of time it does more harm than good. Because if you don't have the cash to pay your tax bill today, how are you going to have the cash to pay it tomorrow, plus pay tomorrow's tax tomorrow. It doesn't work out a lot of the time.
What are tax deferrals?
Just like the company example earlier, you might pay less tax now at 25% but eventually when you get that cash out of the company you're going to pay your marginal tax rate.
If you're running a business in a trust and your accountant says let's distribute that to a bucket company or a corporate beneficiary. It'll pay tax at 30% and we're saving you all this tax aren't we so smart? What they might not be telling you is that bucket company if you want to get the cash out of it, you need to pay your marginal tax rate. If trust doesn't give the company the cash from the distribution it's going to get caught by something called Division 7a loans which is a whole other video, but essentially you need to pay that money back to the company.
Or you might, instead of paying wages or a dividend, the company can just loan you the funds. Loan's aren't income so there's no tax on that. But that isn't making your tax bill go away that's just putting your head in the sand and deferring it until next year when you have probably already spent all the money and don't have the cash to pay the taxes.
Instant Asset Write Offs
So the government of the time makes an announcement of writing off assets in an accelerated way. They'll always pitch it as if this is some big great thing, when all they're really doing is giving you the same tax deduction in one year, as you would have got over a couple of years.
So if you buy a car this year you get to write if off for tax purposes, up to the car limit - you would have got to do that anyway over 8 years, but now you're getting it this year - which bird in the hand and all that, yeah that's cool but it's not actually saving you any more additional tax than you would have already got back.
You can prepay your interest, prepay your rent, prepay your insurance all that sort of stuff. You bring the tax deduction into this year, it just means you don't have it next year, unless you prepay next year as well. Can it be effective? Can it save tax? Yeah if you've got heaps of tax to pay this year, but you don't think you next year, then you could save some tax doing that. It is likely to bring your taxes to $0? Probably not. Most of the time it's just playing around the edges and it's not really a huge benefit. If you're going to incur the expense within 30-60 days of the new financial year starting, and you can just do it now and bring forward the tax saving by 12 months. That makes sense, but at the end of the day it's not saving you any more tax than you would have already saved.
Can we actually save tax? In accounting lingo this is called a permanent difference. Is there a way to pay less tax and there's no kicking the can down the road?
Yes, but they are very limited in number.
Extra Super Contributions
The biggest one is extra super contributions. Your wages will have 10% super on them, you can kick that up to the maximum which is currently $27,500. So if you're paying tax 47% and you put money into super, your super fund only pays tax at 15% you can save a bunch of tax on that. There's some conditions on that if you're a high income earner (> $250k income), but for most people it works. Of course you are locking away all that cash into superannuation until you reach preservation age - also know as retirement. So if you're 45 and you're putting an extra $20k into super, you're not going to see that $20k until your 60 - 65. So yeah it saves you some tax, if you can afford it, it might make sense or it might not.
Some salary sacrifice arrangements can save you money, things like cars, stuff like that is it going to materially change your tax position? No. Will it save you a couple of grand a year, yeah sure.
Exempt Fringe Benefits
Not going to change the world, it's just a couple of hundred to a couple of grand a year, but it could save you some money doing those things, like your business providing lunch to staff on premises on a work day. It's exempt from Fringe Benefits Tax but the company can still claim a tax deduction for it. Obviously if you bought you're own lunch each day, you can't claim a tax deduction for that, so you're saving some tax by doing that. But it's not going to be a huge amount.
Some Other Ideas
Plan your Taxes
Stop worrying about the tax you're paying - I think the issue is you don't know when you're paying your taxes or how much it's going to be and you are getting a surprise. So what you need to do is plan your tax payments. We know when taxes are due, we know how they are calculated, we know when BAS are due we know all that stuff, so using some brain cells we can put together a plan that says ok in these months I'm going to pay roughly this much money on my BAS, on my tax instalment notice - and we're having a cracker of a year so my instalments aren't going to be enough to cover our tax bill so we're going to have a catch up tax bill in May 2 years from now. We know how to do that, accountants know how to do that - it can and should be mapped out, and then every week, every month or every invoice you're transferring a certain percentage of that cash into a separate bank account.
You can have bank accounts for GST, income tax, super, suppliers, wages etc. You can have as many bank accounts as needed to make your cash flow provisioning better. I have clients that do it, and they do it well. They know exactly what they can spend, what is theirs to keep and what isn't.
Effective Salary Sacrifice
Cars, Work-Related Items. Sacrificing them can make them a bit cheaper, but if you get it wrong it actually makes it more expensive so be really careful and get some advice.
Unused Concessional Contributions
This one's been out for a couple of years and starting to gain some traction. There's up to 5 years of unused concessional contribution caps that can be used. So this started in 2019, so it's only 3 years into it, so the full 5 years won't be for another 2 years, but essentially if you've been putting in less than the concessional contribution limit you can catch up those unused amounts so they're not lost. Conditions do apply on that depending on your super balance so talk to your advisor about whether it's appropriate or not for you. But if you do want to do it, there's some scope to get more money into superannuation.
So there you have it, a longish video on the truth of tax planning. Probably bursting some bubbles with my cyncial view of how things work, but taxes and death, the two certainties in life. So be prepared that your tax bill is not going to be $0. The only way it's going to be $0 is if you have all your money in superannuation and it's paying you a pension, or you have less than $20k in income in your own name - and hopefully you have money in superannuation paying you an exempt pension, or your business is running at a loss, and you're having to fund 100% of those losses, which isn't sustainable and you need to do something about that.
The important thing is what you're doing with the after tax cash amount and how you can increase that rather than wiping out your tax bill.
Can you save a few grand? Maybe.
Can you wipe make it go away completely? Absolutely not.