Navigating your first year of business tax obligations

Starting a new business is an exciting venture, but it comes with its own set of financial and legal obligations. One of the most crucial ones is managing your tax.

Imagine receiving your first company tax bill and shortly after, a notice to pay your first PAYG instalment for the upcoming financial year. This scenario often catches new businesses off guard, especially when they are expanding and need their working capital the most.

If they haven’t been proactively saving for their tax bills, some small business operators resort to debt financing or asset sales to cover their tax obligations. Being prepared and understanding future tax requirements can help you manage your business finances more effectively and avoid unnecessary stress.

Here's a brief guide to help you understand what to expect and how to prevent nasty tax bill surprises.

To ensure a smoother financial journey for your business you should engage with your accountant and plan your tax obligations well in advance. See our guide to choosing an accountant.

Initial tax payments

Assuming your business was profitable, in your first year of trading you will probably have to pay tax when you lodge your first return.

It's essential to budget for this and engage in tax planning with your accountant a few months before the financial year ends. This proactive approach will help you avoid surprises and manage your finances better.

PAYG instalments

In your first year of operation, if you have a tax payable on business income of more than $1,000 and a business income of $4,000 or more, and you estimate your (notional) tax to be $500, you will automatically enter the Pay As You Go (PAYG) instalment system. Much like the tax withholding system for employees, this system requires you to prepay your tax for the following year, but you manage it yourself.

However, for businesses run under a company structure, to automatically enter the PAYG system the turnover threshold is $2 million or an estimated tax of $500.

Businesses often report a taxable loss in the initial years, so you may not enter the PAYG system until you start paying tax on your business income. It's important to note that even profitable businesses can report a taxable loss due to adjustments for tax purposes.

Quarterly instalments

Under the PAYG system, each quarter you will pay a set instalment amount or apply a set rate to your income to calculate your payable amount. This is predetermined based on the last tax return you lodged.

If you expect significant differences in your income for the reporting year, you can request a variation. However, be cautious as if you reduce your instalments/payments and end up with higher tax payable than projected, you could face penalties.

Voluntary PAYG 

You can opt into the PAYG instalment system voluntarily. This can be a good strategy if budgeting isn't your strong suit, as it helps you manage your tax obligations more smoothly.

Partnerships and trusts

For partnerships, individual partners must prepay tax on their partnership distributions.

Similarly, if you are a beneficiary of a trust and receive a trust distribution, you will need to prepay tax on that income* as instalments are regular prepayments of the expected tax on your business and investment income.

*Subject to potential thresholds

Case study

A café operated under a company structure generates a revenue of $250,000 and a taxable income of $50,000 in their first year and any other income made by the company, minus allowable deductions.

First year trading assumptions 

In the first year of trading, the café will pay its tax when it lodges its first tax return. Given a taxable income of $50,000, the company tax rate for small businesses is currently 25 per cent. 

The tax payable would be worked out as follows:

Second year trading - PAYG instalment system

Since the taxable income in the first year is $50,000, and the tax payable is more than the threshold, the café will automatically enter the PAYG instalment system to prepay the tax for the following year. 

The company will receive an Instalment Activity Statement (IAS) or a PAYG Instalment section will be added to the Business Activity Statement (BAS). The ATO provides two methods to calculate PAYG instalments:

Method one: instalment amount 

This is a set instalment amount to pay each quarter (regardless of revenue/takings), based on the previous year’s tax payable, irrespective of the quarterly income.

If the café expects a significant change in income for the year, it can vary the instalment amount. However, this should be done with caution, as underestimating the tax liability can result in penalties. 

For example, if the café estimates its revenue will be lower and reduces its instalments, but ends up with a higher turnover and therefore a much higher tax liability, the ATO may impose penalties for underpayment. Conversely, if the tax payable is lower than expected, any overpaid instalments will be refunded after the café owner lodges their tax return.

Method two: instalment rate 

Alternatively, the taxpayer may choose to apply a predetermined rate to the income for each quarter, which is also based on the tax payable in the first year. For example, if the revenue was $250,000 and tax payable was $12,500, the instalment rate would be 5 per cent. 

The company would then apply this rate to its actual income (takings) for each quarter to determine the instalment amount. If the café earns $70,000 in a quarter, the instalment for that quarter would be $3500. Calculated as follows:

In summary, in this example, the company (café) will, in its second year of trade;  

1. Pay the first year's tax of $12,500 when lodging the first tax return (and enter the PAYG instalment system for the second year).
2. Pay the first PAYG instalment - in the quarter following the lodgement of the tax return. This means that in addition to the $12,500, the company will also pay the first PAYG instalment (either $3,125 or $3,500, depending on the method used).
3. Be cautious with variations to lower instalment amounts to avoid penalties for underpayment.

How to know when PAYG instalments apply to your business

Worried that entering the PAYG system may take you by surprise? Relax - the ATO will let you know when you have entered the PAYG instalments system.

• If you are registered for myGov with a linked ATO account, you will receive a letter in your myGov Inbox.
• If you have Online services for business, or Standard Business Reporting software, you will receive your instalment information 21 days before the due date.
• If none of the above applies, you will receive a paper letter in the mail.
• If the ATO has your mobile phone number they will also remind you via SMS.

They will also let you know how much to pay, how often and by when.

More information

• Get an overview of tax requirements for small Australian businesses
• Stay up to date on the tax reporting requirements for small businesses.
• Learn how to get ahead at tax time with our expert tips. 
• For more information on PAYG requirements and the latest updates, refer to the ATO's guidelines on PAYG instalments and information on starting PAYG instalments.