Sam Rubin
Technical

Own Business vs. Salaried Employee – cash flow requirements

By Sam Rubin

As you know many Australians have been made redundant from their positions over the past year. The latest labour force figures (July 2009) released by the Australia Bureau of Statistics show an increase in the unemployment rate from 5.8 per cent to 5.9 per cent for the month. That equates to 670,000 people unemployed.

Individuals who have been made redundant can utilise the time and the capital to reassess their careers and lifestyles. Many may also decide to start running their own business. Financial planners can assist clients who are thinking about becoming self-employed by discussing business structures available, taxation issues and overall family cash flow needs. One of the biggest questions is what income is required from the business to cover living expenses?

This article will attempt to discuss these issues via the use of the case studies below.

Case Study One

John aged 45 has recently been made redundant from this long term employer of 12 years. John was employed as a Marketing Manager earning $100,000+ SG (net weekly pay was $1,405 or $73,050 pa). Sophie, John’s wife works casually earning approximately $12,000 pa (net weekly pay is $231) for extra pocket money to cover hers and the kid’s lifestyle requirements.

John and Sophie have been reassessing their lifestyle and have been thinking about using his redundancy payment of $85,553 (net, gross $100,000) to start their own business.

Their current weekly cash flow required is as follows:

Cash Flow Items – Per Week
$
Salary – John
1,405
Salary – Sophie
231
Total Net Income
1,636
Weekly Expenses
$
Groceries
300
Mortgage Costs
500
Vehicle Expenses
200
Entertainment Expenses
200
Children Expenses
200
Total Weekly Expense
1,400
Surplus Weekly Cash Flow
236

John and Sophie decide, with the help of their financial planner and business adviser, that the best business structure for the business would be a partnership. They have also used majority of the redundancy payment to repay their home mortgage and will draw against the home to start the business therefore providing greater tax efficiency within the business as tax is only payable on business profit and not owner’s drawings.

Their weekly cash flow requirement has now reduced from $1,400 to $700 (given no mortgage costs and vehicle costs now paid by the business). What annual income do they now need to draw from the business? They need to draw around $36,400p.a. assuming no tax is payable given available deductions within the business. Even if tax is payable, John and Sophie can withdraw funds from the business to cover the costs.

The important message from this article is that generally clients will need less gross income from when they were an employee to being self-employed. The reason for this is the deductions available to businesses compared to individuals claiming work related expenses, and the ability to have expenses covered by the business e.g. vehicle expenses.

Case Study Two – Electrician Employee vs. Business Owner

Alex is a qualified electrician that is employed by Ace Electrical earning $60,000p.a. He currently drives to his employer’s house and then goes out to jobs with him. Alex has his own tools but only uses the employer’s tools. He has minimal personal tax deductions to claim against his employment income. Assuming he can only claim $1,000 in deductions his net salary is $47,755p.a. (net $918 pw).

Alex has an opportunity to run his own electrical business with approximately $65,000 in business revenue. Alex could run the business under a partnership structure with his wife (not in paid employment) and run the business from home. The annual expenses of the business will be:

Vehicle Expenses $6,000
Depreciation of Tools $5,000
Business Admin Expenses $3,000
Advertising Expenses $3,000
Banking Costs $1,000
Interest Costs $3,000
Home Costs – Room, Utilises & Phone $10,000
Total Business Costs $31,000
Taxable Income $34,000
($17,000 each)

Total tax payable assuming no other income would be $600. This means that even after cash flow costs in the business of $10,000 (not including vehicle costs, home costs and depreciation) Alex will still be able to withdraw $54,400p.a. out of the business which is $6,645 more than he was earnings as an employee and he has the flexibility to work his own hours.

The dream of running a business is a far-fetched scenario for some individuals, often because of existing cash flow commitments and meagre savings. Educating your clients about the fact that current gross employment income required may not be the same as business income required, can help to make the dream a little less far-fetched.