Sam Rubin
Technical

Small to medium enterprise (SME) clients & superannuation tax planning

By Sam Rubin

For many small business owners the drawings/salaries they receive from their business are generally based upon the cash flow requirements of the business and their accountant’s recommendations. SME business owners should discuss these issues also with their financial advisers to plan for what the business owner requires in five, 10 or even 20 years time rather than simply focusing on tax planning for the current period.

Financial advisers have the opportunity to work with SME business owners, not just focusing on their superannuation or investment portfolios, but to understand their business model and structure, business revenues and expenses, and overall capacity to withdraw funds from their business.

Financial advisers advising SME business owners need to go one step further than the traditional Fact Finder and also ask the following questions:

  1. What’s the business of the SME and its FBT status (E.g. Rebatable, Full or PBI)?
  2. What is the business structure e.g. trust, sole trader, company?
  3. What is the revenue generated by the business?
  4. What is the business EBIT and adjusted EBIT?
  5. Who in the family is employed in the business and are they receiving market rate salaries (including employer contributions)?
  6. What are the non-business expenses that are held and paid by the business e.g. family car?
  7. Does the business have any surplus cash available to be withdrawn if we ignore taxation issues?

This information should assist advisers to understand the current cash flow source and profitability of the business and should assist in the advice recommendations incorporating the business assets.

Case Study

Martin and Judy aged 52 and 50 respectively, run a successful IGA Grocery franchise in rural Victoria. They have in the past only received advice from their accountant regarding tax efficiency and family cash flow requirements. The business is owned by the family company with Martin and Judy both directors and shareholders.

Martin and Judy have two children aged 16 and 14 who both help out after school and during holidays.

The business EBIT last year was $250,000 (after owners’ salaries) and has been growing by 12% p.a. over the last five years. The business has surplus cash and franking credits of $150,000 invested within the company.

The business premises are owned by Martin and Judy jointly and receive $30,000 p.a. in rental income from the business.

Martin and Judy have only been receiving small salaries of $20,000 p.a. each to cover their 50 hours they work each week, which provides them with sufficient cash flow to cover family living expenses. Their current living expenses are $45,000 p.a. but the couple would like around $10,000 each year to cover a family holiday. The remaining cash surplus (approx. $8,500 p.a.) has been paid directly into their home mortgage - currently at $80,000.

Martin and Judy would like to meet their long term objective of selling the business and having a comfortable retirement in eight year’s time. Our recommendation should be based around maximising contributions to their superannuation accounts and increased tax efficiency across all their assets.

Solution - analysis

Firstly, have we got all the information required to be able to provide specialist SME advice to Martin and Judy? No, we still need information about the business revenue ($2,500,000 from previous year’s financials), adjusted EBIT figures, the market rate salaries that would be required to cover the family members’ positions and the market rate rental for the business premises.

Martin and Judy provide you with the market rate figures of $65,000 p.a. (based on current employees’ salaries) for each of their positions within the business and state their two children complete around 700 hours each within a year that would be at minimum wage of $14.31 per hour (total annual cost of $20,034 ignoring SGC), whereas currently they receive no income from the business. The market rental for the premises would be around $60,000 p.a. (based on an independent real estate assessment).

Therefore we can now determine the adjusted EBIT return of the business as:

EBIT
$250,000
Add Backs
Rental
$30,000
Total Owners - Wages
$40,000
Less
Market Rate Rental
$60,000
Market Rate - Salaries
$150,034
Adjusted EBIT
$109,966

This tells us that the business goodwill value should be approximately $458,500 based on an assumed capitalisation rate of 4.171 multiplied by the above adjusted EBIT figure. Note: to be able to assist SME clients with true pre-retirement planning, you would need to receive a full independent valuation of the business.

Based on the other information provided by Martin & Judy, it has been determined that they will require around $1.1 million in retirement capital in today’s dollars, so we will focus on building their superannuation savings.

Solution - recommendations

Withdraw $150,000 fully franked dividends

Martin and Judy have the ability to withdraw up to $45,000 each, each year and not be subject to additional tax payable due to franking credits held within the company. This means surplus cash flow within the company of $150,000 can be distributed to shareholders as dividends over a two year period. These funds should then be contributed to each of their superannuation accounts as earnings are only taxed at a maximum of 15% compared to the company rate of 30%.

Increase Martin & Judy’s salary packages

The business can afford to increase the salaries of the owners, so why not consider the benefit. You could consider increasing their salaries each by $48,200 and then they could elect to salary package the increase to superannuation bringing their individual concessional contributions to $50,000 p.a. ($48,200 + SG $1,800) at least until 30 June 2012 when the transitional cap expires.

Pay market rental for business premises

Increasing the business premises rental to the market rate of $60,000 p.a. will provide a neutral tax position and give additional revenue to Martin & Judy, who will still be taxed at the same rate of 30% as the company. The net cash benefit of $20,550 could be used to re-pay the home mortgage sooner or contribute funds to superannuation as a non-concessional contribution.

There may also be an opportunity to in-specie transfer the business premises to a SMSF but that will depend on CGT and stamp duty costs, valuation and any debt against the property. Rental income will then be taxed at a maximum of 15%.

Market rate salaries to children

The opportunity of paying their two children each around $10,000 p.a. tax free in salaries will assist in withdrawing more funds from the business and therefore the ability to contribute to superannuation to assist in saving for retirement and overall greater tax efficiency. The income will be exempt from minor’s tax rate due to the nature of the income. Also note that Martin and Judy could pay the kids each up to $15,000 p.a. tax free.

Note that all these strategies/opportunities need to be discussed with clients to make sure that the surplus funding is better out of company and working in superannuation compared to later realising that they needed the funds to capitalise the business for future growth prospects. Also the above recommendations can have an impact on a range of Government benefits like Family Tax Benefit Part A & B (for more information about this, refer to my article published in the July IOOF @dviser magazine).

Financial advisers servicing SME clients should also discuss their recommendations with the client’s business accountant as generally these professionals have been supporting the owners for a long time and been advising them what salaries and rental to charge. If we go back to basics, generally a financial adviser’s role is to assist clients meet their future financial goals and objectives whereas accountant’s roles are to report on the past and current business activities. Both professionals are vital in supporting the client to meet their legal obligations and plan for their own future.