Coming up to 30 June, so many stores are advertising with tax advice that should always be taken with a grain of salt. Spending all your profit to pay $0 tax isn’t a long-term strategy. A better strategy is to focus on what your post-tax net income is, and what it should be.
The decision to purchase something for your business should be budgeted for from a net-profit perspective, not simply because it provides a tax deduction.
“Will buying this thingamajig help me earn more from my business?”
is the first question to ask.
The second question is: “How much does this “tax-deductible thingamajig really cost me”
…. rather than simply “How much do I get back on tax?”.
The “instant-asset write-off” may allow you to claim a 100% tax deduction for a new $5,000 computer, for example, but you don’t get $5,000 back as a reimbursement or tax refund. This is because the $5,000 only reduces the assessable income that you would otherwise pay tax on.
Would the second-hand $2,000 computer re-build be a better option? Would it still allow you to earn the same income as the more expensive option would, and allow you to develop the same intellectual property assets to earn future passive income from? If the answer is yes, or maybe, then compare the post-tax costs of both options and consider your financial priorities.
Let’s compare the real post-tax cost of both options. In this example, to keep it simple, we ignore Medicare levies, HELP debt repayments and tax offsets:
Emma is a GST-registered self-employed designer whose taxable income for 2020 will be $94,000, which is in the 37% tax bracket. She’s about to max out her credit card on a new $5,500 custom-built computer to claim a tax deduction before 30 June.
Firstly, she will reduce her June BAS bill by $500, by claiming the GST paid on this capital purchase.
By claiming a tax deduction of $5,000 in her 2020 tax return, her taxable income will be reduced to $89,000, which is in the 32.5% tax bracket, and it looks like this:
Income tax on $94,000 = $22,277
Income tax on $89,000 = $20,472
Income tax saved = $1,805
GST saved = $500
Total tax saving = $2,305
Net position after tax = $89,000 + $2,305 = $91,305
If Emma thinks this strategy would save her 4.5% tax on her whole income by going into a lower tax bracket, or that she’d be directly refunded $5,000 (both are common misconceptions), then she’d be very disappointed when her accountant tells her she still has an annual tax bill, albeit less of one. She’s also stuck with a credit card debt incurring an interest cost, further eroding the mere $2,305 tax benefit on a $5,500 outlay.
If Emma bought the $2,200 GST-inclusive computer instead, it would look like this:
Income tax on $94,000 = $22,277
Income tax on $92,000 = $21,537
Income tax saved = $740
GST saved = $200
Total tax saving = $940
Net position after tax = $92,000 + $940 = $92,940
Despite the smaller tax saving of a cheaper computer purchase, Emma is actually $1,635 better off because her after-tax income is now higher. She is less out-of-pocket and would also only have a $2,200 credit card debt to manage.
Next – Emma considers if she could bear being $1,635 worse off to have the more expensive and better-performing sexy computer delivered right now:
So, she prepares a 12-month cash-flow forecast to see whether she will be left with enough to live on while paying off the credit card debt.
It’s hard to predict revenue in the current uncertain climate but things seem to be going along better than expected, with her main client renewing their delayed contract this month, and she’s starting to pick up a few smaller jobs. To be on the safe side, she factors JobKeeper out of the equation as the government could cancel it before September, who knows?
By using the credit card calculator on Moneysmart.gov.au, Emma discovers that the $5,500 purchase would cost her $500 a month in repayments, over 12 months, including $958 in interest charges at 18%. The interest charges will be eventually tax deductible in her 2021 tax return, but that only represents around $350 tax saved in a year’s time.
By stretching the card repayments out to 24 months, she reasons that $279 a month is within her cashflow budget … but the $1,453 interest cost is off-putting to her, even if she “gets back” around $500 tax over the next two years of tax returns.
Emma then tests the $2,200 credit card purchase with the Moneysmart calculator, feels that’s more within her budget for now and she could still get the job done and earn her current income with the cheaper work horse. She figures that instead of paying off a credit card, it may be more sensible to put aside some money each month to buy the better computer next year, after the price goes down and when ongoing income becomes more certain.
That evening, a friend tells her about how she could save so much more tax and continually upgrade her technology by leasing. Prior to assessing alternative finance options, it is important to note that with any purchase of equipment, a similar cost-benefit analysis should be undertaken to ensure that (1) the revenue generated from the equipment provides an adequate return on investment, and (2) sufficient cashflow will be available for monthly payments and any final payments. If Emma cannot afford to keep up the payments, she may lose the computer and her ability to earn an income. Like the above examples, tax is a minor part of this bigger equation.
Of course, if Emma has a spare $5,500 to buy her business equipment outright and is confident of ongoing income, then finance costs aren’t an issue, and she’d only be interested in her net position after tax.
However, if she’s planning to apply for a home loan soon and needs her taxable income to appear higher in her 2020 tax return, not less than $90,000 for example, then she may defer the purchase until next tax year or buy the cheaper computer. In this situation, querying this with her mortgage broker would be more important than asking her accountant for a tax opinion.
Let’s say Emma’s mortgage broker assures her that a $89,000 taxable income will not disadvantage her application for a certain amount of home loan…
So Emma emails her accountant: “I just have a quick question: Should I buy a $5,500 computer before 30 June?”. How her accountant replies should tell her how good her accountant is…
Her accountant quickly replies:
“Sure, Emma, you’ll save $2,305. Sounds like a great idea”. Emma is thrilled, runs out and buys the computer on her card and tells her friends she’s got the best accountant in the world who saved her over two grand.
Sorry, that was NOT the best accountant’s reply!
Emma’s best accountant ideally replies:
“Emma, I’ve done some quick sums based on what I can see of your current income in Xero. The $5,500 computer might save your $2,305 in GST and income tax. But before you jump on that, let’s look at your updated cash flow forecast and consider that home loan application you mentioned last time. With revenue down 30% on last year and your profit margins tightening with increased costs, I think we’ll need to check a few things with you before recommending anything”.
Then Emma books meeting with her accountant to look at the bigger picture and compare a few scenarios. This results in an actionable plan based on real data instead of gut feeling.
It might be easier to say, “My accountant saved me $2,305 tax”, but the accountant who can offer a more holistic and structured analysis can save a business owner much more in the longer term.
A good business accountant is more likely to identify areas of undercharging and overspending that could be improved before you make a decision that reduces your bottom line… irrespective of tax effects.
Of course, it’s also going to cheaper for an accountant to give the easier incomplete answer, which is easier for a sole trader on a lower income to justify than for an SME business with bigger sums at stake. But if a creative sole-trader has personal financial goals and wants to buy a home, invest in assets, or scale up their operations…. then business financial advice is just as important as personal financial advice. A business budget must be done before a personal household budget.
After all, it’s the bottom line of the Profit and Loss report – the Net Profit After Tax – which represents how much you take home from the business. How much you get to live on. How much you can save. How much debt you can bear. How much you can spend in future.
Tax is only worked out at the end, and from this perspective is just another expense that reduces your Net Profit.
Bear in mind – if your Net Profit is so low that your taxable income is below tax-free threshold, or in a low-income bracket (i.e. under $37,000) then any tax savings from further deductible expenditures with be nothing at all or negligible. Tip – before you consider buying that computer or whatever deductions, have your Profit and Loss ready to work out your Taxable Income and check the percentage of tax you would save in that income tax bracket. (google ATO individual tax rates).
Managing these tax decisions well requires monthly, not yearly, attention to all the figures. If you’ve only been doing this yearly or quarterly, now is the time to make a monthly commitment. If the nightmare of accessing JobKeeper has taught us anything, it’s that monthly reporting and forecasting is no longer optional. This way, you learn to know how much tax you’ll owe as you go along so the annual tax panic becomes a thing of the past.
We hope this was helpful. Please contact us without delay for advice specific to your circumstances.
The material and contents provided in this publication are general and informative in nature only. This article is not intended to be advice and you should not act specifically on the basis of this information alone. If expert assistance is required with your own affairs, professional advice should be obtained.