Free kick? It depends on the company you keep
Inevitably the debate is often based on half truths and confused expert opinion. One criticism is the massive free kick the wealthy will get. When you look at the income tax laws, there are several reasons why operating through a company does not provide any tax benefit.
There are other benefits, such as limiting the legal liability of the owners. But when it comes to income tax a company, at best, delays the paying of tax by the owners. Where a person chooses to earn what is really employment income through a company, in the belief that they will benefit from the lower company tax rate, there is a section of the tax act that effectively negates them receiving any benefit. This is the alienation of personal-services income section.
Someone classed as being in a personal-services income business must pay income tax paid on profits made by the company at their applicable marginal tax rate. This tax must also be paid on at least a quarterly basis. There are severe penalties when a person running a personal-services business through a company does not regularly pay income tax on profits made to the ATO at their tax rate.
Even if the alienation of personal-services income section did not apply, operating through a company does not really provide a tax break for the owners.
After a company makes a profit and pays tax at the company tax rate, it must be taken as dividends that are then taxed at the owner's tax rate. If any after-tax profits are taken by the shareholders other than as dividends, they are shareholders that take accumulated profits from a company - not as dividends - and end up with a loan owing to their company.
Unless these loans are treated properly, having interest charged on the loan at a high statutory rate that must be repaid within seven years, they are treated as an unfranked dividend, and the owner pays tax at their applicable marginal rate on the profits taken.
This means no real tax benefit is received when an individual earns income through a company, no matter what the company tax rate is, unless they are prepared to leave the cash and profits in the company. Even if someone is prepared to do this, there is a major disincentive and tax penalty if a company is used to buy investments that will increase in value.
This is because companies do not receive the 50 per cent general discount that individuals do when capital gains are made.
Someone on the top tax rate pays 23.25 per cent on a capital gain as long as the investment has been owned for at least 12 months.
Because a company does not get the 50 per cent general discount it will pay tax at 28.5 per cent on all capital gains.
The main losers from a drop in the company tax rate will be those that depend on fully franked dividends for their income.
Frequently Asked Questions about this Article…
The proposed 1.5% cut to the company tax rate has sparked debate about who wins and who loses. For everyday investors the effect depends on how income is earned and distributed — many individuals who earn income through a company may not see a real tax benefit because company profits are eventually taxed at the owner’s marginal rate when paid as dividends.
Generally no. Operating through a company can delay when you pay tax and limits legal liability, but it doesn’t usually provide a permanent income tax break. If you earn what is effectively employment income through a company, specific tax rules typically prevent you from benefiting from a lower company rate.
The alienation of personal‑services income rules target people who earn employment‑type income through a company. If PSI rules apply, the company’s profits are taxed at the individual’s marginal rate and must be paid to the ATO at least quarterly. There are severe penalties if a person running a PSI business doesn’t regularly pay tax on those profits.
After a company pays tax on profits at the company rate, those profits taken as dividends are then taxed at the shareholder’s marginal tax rate. If shareholders take after‑tax profits out as loans or drawings instead of dividends, they can end up owing the company money and, unless repaid or treated correctly, those amounts can be treated as unfranked dividends and taxed at the owner’s marginal rate.
You could leave cash and profits in the company to defer tax, but that isn’t always advantageous. The article notes a major disincentive: companies do not get the 50% general capital gains tax discount that individuals receive, so holding investments inside a company can be tax‑inefficient for long‑term capital growth.
Individuals receive the 50% general CGT discount for assets held at least 12 months; the article notes someone on the top tax rate ends up paying about 23.25% on such a capital gain. Companies do not get the 50% discount and will pay tax on capital gains at the company rate (about 28.5% as described).
According to the article, the main losers from a drop in the company tax rate are people who depend on fully franked dividends for their income, because changes in company tax rates can affect the value and franking of dividend income.
Yes. One clear non‑tax benefit of operating through a company is that it can limit the legal liability of the owners. But when it comes to income tax, the company structure typically only delays tax rather than providing a permanent reduction for individual owners.
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