Most small business owners are pretty close to their business. For many, it is a major part of their life and the distinction between personal and business is easily blurred.
This can also cross over to their financial affairs with business and personal finances being interlinked.
However, some recent tax cases are a reminder of the risks you run if you don’t keep sufficient separation between personal and business.
The risk occurs where you are operating your business through another entity such as a company or trust. Get it wrong and you can lose some valuable tax deductions.
Operating via a trust or company is very common and makes good sense from an asset protection and separation perspective. The problem occurs when you incur expenses on an individual basis, on behalf of your business, and then seek to claim tax deductions for them.
The most common example of this is interest costs on borrowing.
For example, your business needs funding and the bank is reluctant to lend directly to your company but more than happy to lend to you.
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Or you decide it would be better to borrow at a personal level because you can secure a much better interest rate.
All makes sense so far. You are your business. What’s the difference in whether the business borrows the funds or whether you borrow them and let the business repay the loan?
The problem comes down to who is entitled to the tax deduction. If the loan is in your individual name, you may want the tax deduction for interest paid at a personal level.
You can only achieve this if there is a reasonable nexus between the interest incurred and income you derive from your business. And simply earning salary or wages from the business is unlikely to satisfy this.
The courts’ position is that an employee is not normally required to provide funding for their employer, so the fact that you earn a salary from the business will not be enough.
You need to show a clearer connection. This could be from dividends you are receiving (probably unlikely in the first couple of years of business life) or directors’ fees. The best evidence is where you have on lent the money to the company and are charging a rate of interest.
In this case you would have both interest income and an offsetting expense.
If the loan is in your personal name, also be careful about just having the company make the repayment and claim the interest deduction. Your company could run into Division 7A problems and trigger an unexpected tax outcome.
Another common risk area is business expenses claimed at a personal level, particularly if you operate your business through a discretionary trust.
Where your sole source of personal income is from trust distributions, you are unlikely to be entitled to claim any tax deductions on the basis that they are expenses incurred in earning your income. The reason for this is that as a beneficiary of your trust you have no right to income until the trustee appoints that income to you at year end.
You do not have an automatic right to the income. And at the time you incurred the expenses throughout the year, eg. car expenses, you had no income.
You simply had an expectation that the trustee would appoint income from the trust to you at year end. Unfortunately that’s not enough.
The clear message is that you need to put some formality around arrangements where the personal and the business cross over.
Yes, you and the business are almost one – but not from a tax perspective. Get this wrong and it can be expensive.
Greg Hayes is a director of Hayes Knight and specialises in taxation and business planning advice.