Finance and the self employed - business and contractors

The reason many contractors get into trouble with finance is they structure their employment via a business entity and are thus defined as self employed. This is done so people can write off their mobile phone, lap top, a bit of fuel and a few other things as business expenses. Interestingly I've often observed that the costs of business registration, business and tax compliance often means they're not that far ahead.


Why lenders want tax returns for the self employed:

Lending money when you operate as a business is difficult and requires a trading history and tax returns. Many people argue that they can show how much they make via their invoices and payment history. The problem is it also costs money to run a business (mobile phone, lap top, a bit of fuel, costs of business registration, business and tax compliance to name a few). To understand how profitable a business is, a bank needs to know their expenses as much as they need to know the income.

A general response to the problem of proving would be to show the expenses but it's too easy for a business not to report expenses to the bank and thus artificially increase their profitability. As a result the only way a lender can reliability ascertain the true profitability of a business is to rely on the tax returns and business profit & loss statements.

The other challenge is that lenders also know that many businesses fail, or that people can manipulate their business figures to show high profits one year at the expense of less profit in another year. As a result most lenders want 2 years of reasonably consistent tax returns, and the exceptions still want that business to have traded for at least 2 years.


What's the solution?

There isn't a simple solution to get finance when you're self employed. Lenders will require the business tax returns, usually for at least 2 years. Furthermore the tax returns need to show reasonably consistent profits, this harks back to the lenders knowing that one year can be manipulated to make another look good. Even the lenders what only require a single years returns will want the profit and loss statement. This document shows the profitability for the last 2 years, so there's no magic bullet here.

As a result, the solution is simple. Run a business profitably. This will mean the business owner pays more tax but it also means that lenders will be happy to lend against those profits in the same manner they'll lend against an employees salary. I've also noticed the side effect of operating a business to show profits seems to be that the business is truly more profitable and sustainable in the long term. They're also more valuable and have a higher resale value.


What about lo doc loans?

Prior to the GFC lo doc loans were quite easy qualify for. A GST registered ABN for 2 years, a declaration of profitability and you're good to borrow as much as you want. In 2011 however, responsible lending legislation became effective and lenders are required to take reasonable steps to verify profitability before they can fund a loan. A simple self declaration isn't enough to do this.

Thus some steps need to be taken to verify a persons or business' income and profitability. Lenders acknowledge that there is a lot of grey area in business profits so the verification doesn't have to be absolute, but it still has to be reasonable. For lo doc loans, lenders offering them will require at least one (often two) of the following:

• An accountants letter stating the profits of the business based on the accountants knowledge. Unfortunately accountants don't want to lie to the lender, ASIC and ATO, so they tend to simply repeat what the last tax returns say. If that profit was going to be enough, you probably wouldn't need the lo doc loan.
• The last 12 months BAS statements, which is essentially a lead up to the next tax return anyway. If your tax returns aren't showing healthy profits, odds are your BAS statements aren't either.
• 12 months trading statements for the business or self employed person. The problem here is if a business isn't going to show a profitable tax return, their bank statements aren't going to look so great either. I've often found that showing lenders banks statements generates more questions than answers. It can be a can of worms that probably ends in the loan application being declined.

There are cases where lo doc loans are the best solution. Some business models show significant profits over time periods of 3-5 years, but some years would have significant losses. The years where people want finance have an odd way of being the years when those losses also occur. Sometimes there's a massive tangle of multiple business entities which is a paperwork nightmare to sort through and a lo doc loan makes sense.

Whilst lo doc loans can be justified in some scenarios, he bottom line is they can't be used to cheat and get around profitability requires for the self employed.


Let's go back to the single contractor:

This might be the IT professional who sets up a small company via which he's employed on an ongoing contract basis. They only work for a single employer at any given time and effectively they're just another employee on a contract. They're simply trying to optimise their tax position a bit better.

The question really needs to be asked, "Is this necessary?" Maintaining a business entity does require compliance with ASIC, regular BAS statements, extra tax returns. This cost of doing this easily runs to over $1k / year, sometimes quite a bit more. The benefit is most people claim their mobile phone, some car use, home office expenses, training, etc. Interestingly I found that when I was a PAYG permanent employee in the IT industry, I was able to keep a log book of usage for many things, and my accountant allowed me to claim a lot of these expenses anyway.

It often makes me wonder if the accountants recommendation for someone to set up a company is somewhat self serving as the accountant gets to charge extra for the advice and company returns.

Many employers are quite happy to simply enter into a contract with an individual on a PAYG basis, as are recruitment organisations via which many contractors are employed. Despite what many people believe, it's not hard to qualify for finance under these circumstances even when you bounce from one contract to another every 3 months. It helps if you keep copies of previous employment contracts and ask for employment letters when you leave (this is not a reference, just a statement of employment which you're legally entitled to, even when you're sacked).


Conclusion:

If you're self employed and operating a business, you should already understand the need for a business plan. Applying for finance is no different, it requires forethought and planning. Understand what lenders require and why they have those requirements, then plan to that outcome. Run the business profitably and you'll not only be able to qualify for finance, but you'll likely have a better business. It seems to me that paying tax is a direct result of making money. It's not a sin to pay tax (only to pay more than you should).

If you're an employee contractor, ask yourself if it's really necessary to do this through an ABN or business. There might be some benefits, but is it really worth stalling your home ownership or investment strategy? A few dollars in your pocket could have serious effects on a lifetime of wealth creation.

Consider that building a business should not only earn you an income, it should be building an asset which has value and can later be sold. A contractor who sets up a business to get a few tax deductions isn't building an asset, they're only earning an income. A real business, large or small, can be sold for a profit. It's also worth noting that an investment strategy doesn't have to be buying properties or shares, building a business should also be considered an investment strategy. When you can't qualify for finance, focus on turning your business into a better asset instead.

 

Great article but as a contractor, I wasn't given a choice.

 

Another common issue is that people would prefer to withhold "real" income amounts in order to pay less tax but then once its time to get a loan different story.

 

Hi Guys,

Since ICT contractor (who work on daily/hrly rate) are mentioned as casuals (in their emp contract) even if they work for a min 40 hr/wk for the term of contract.
Just wondering if they find difficult to get a home loan?
Also when they switch contract can they get loan at the start of new contract (as there is no probation period)

ICT contractors specially in Canberra are paid around 90+/hr or 700+/day for the contract term of usually 2000hr (ie one year).
ICT contracting in canberra is a matter of choice rather then inability to find permanent jobs, Contracts are usually long term gov contracts

 

Thanks for posting this Peter. Seems to be plenty of people who admit defeat just because they don't have normal payslips. There's often more that can be done if they seek out the right broker for advice.

 

Piece of cake. Not all lenders are going to like it, but 3 months employment history will get you plenty of options. Not all that different from permanent employment.

 

Thanks Peter & Rolf

 

Hi Peter, great post. Is your quote above still the case in today's lending landscape?

 

Still plenty of options. Not much has actually changed on this topic.

 

Still all extremely relevant.
I'm PAYG but claim a whole heap of similar expenses to S/E, my taxable income is decreased a lot by these expenses come tax time.
But for finance I'm able to use my gross PAYG income.

 

Excellent Post Pete

 

From someone who works in IT closely with finance for a recruitment company I have spent countless hours on the topic of contractors.

Along with the things Peter mentioned we make it mandatory to only engage with those who have Workcover, Professional Indeminty & Public liability so add all those costs into the mix.

This may be harsh but the reality is that most people are doing this for two reasons.
1 - They get paid before they pay tax so we all know what that means.
2 - They would prefer to NOT pay super. Don’t get me wrong I have my issues with super but I have more issues when people don’t plan for their future. If it’s being redirected instead to other asset classes then all good. If not though...

As Peter said, I wonder who is suggesting this structure most the time? As a PAYG I’ve never had any issues claiming a lot of the same expenses a contractor is entitled to.

And just an FYI it’s the employee who dictates the structure they want to be paid at when working through a recruitment company. Our clients nor do we say “We only want contractors”. If the role is a “contract” doesn’t mean you can’t take it and be paid PAYG.

 

I see few of them actually set aside super OR an alternative. Its always something they will do.

I also note one of the serious problems with contractors and sole traders etc is they have NO workers comp. In the event they face a workplace injury they may have no recourse for loss of income for a lifetime. Its your greatest asset in most cases.

Generally speaking a contractor who does not operate a true small business cannot claim any more or any less than an employee. Many seem to falsely believe that as a contractor is a way to increase deductions and include private costs.

 

Your a very wise man Paul and great to see this response from someone who is the one dealing with the end result.

** I must add a disclaimer that I dislike contractors solely on the amount of additional work and headaches they cause me in my daily job! I am implementing an entire new system at the moment and the amount of customization we require for 50 contractors is exhausting.

 

Sounds like the tail is wagging the dog! You'd think that contractors would be required to work with their clients systems.

For many reasons, including those outlined by Paul, I'm not a fan of contractors operating under an ABN. It rarely delivers much extra tax deductions and it comes at a significant cost.