Salary, Dividends, Director Drawings: Why Classification Matters in a Company

For a company director, it can be easy to view the business's funds as an extension of personal finances. However, the classification of money taken from the company—as a salary, dividend, or director drawing—carries significant financial and legal consequences under Australian law.

Incorrect classification is not a minor bookkeeping error. It is a compliance issue that can attract the scrutiny of the Australian Taxation Office (ATO), result in unexpected tax liabilities, and potentially breach the Corporations Act 2001. This guide analyses the regulatory treatment of each payment method for the FY 2025–26 financial year, providing a framework for compliant decision-making.

From our observations at Baron Tax & Accounting, many new company directors in Brisbane are not fully aware of the strict legal distinctions separating these payment methods. This is a frequent compliance oversight, often leading to issues with director loan accounts and unforeseen tax obligations.

The Core of Classification

The central issue is defining the legal nature of the payment. Is it remuneration for labour, a distribution of profits to shareholders, or a loan from the company? This classification determines the subsequent chain of compliance obligations.

A clear breakdown is as follows:

• Salary: Remuneration for work performed as an employee of the company. It is a tax-deductible expense for the business.

• Dividend: A distribution of the company’s after-tax profits to its shareholders, representing a return on investment.

• Director Drawing: A withdrawal of funds that is not classified as a salary or a dividend. Legally, this creates a loan from the company to the director.

The business structure selected provides the foundation for these remuneration decisions.

Exploring Salary as Formal Director Remuneration

Treating director remuneration as a formal salary is the most transparent and compliant method. It clearly establishes an employer-employee relationship between the director and the company, which activates a specific set of non-negotiable compliance duties.

This approach formalises the director's role, transitioning them from a shareholder to a working employee on the company payroll. The primary advantage is that the salary and associated superannuation contributions are tax-deductible business expenses. This directly reduces the company's taxable income, potentially lowering its overall tax liability.

Key Obligations of Paying a Director Salary

Once a director is placed on the payroll, the company must adhere to the same rules applicable to any other employee. These obligations are administered through the ATO’s tax and superannuation systems.

The main responsibilities include:

• PAYG Withholding: The company must calculate and withhold the correct amount of tax from each salary payment, using official ATO tax tables. This withheld tax is remitted to the ATO on a regular basis.

• Superannuation Guarantee (SG): The company is required to pay super contributions into the director’s nominated superannuation fund. For the FY 2025–26, the Superannuation Guarantee rate is 12% of ordinary time earnings.

• Single Touch Payroll (STP): Every salary payment must be reported to the ATO in real-time through STP-enabled software, keeping the tax office informed of wages paid and tax withheld.

Crucial Compliance Point: Failure to meet these obligations can result in the ATO issuing a Director Penalty Notice (DPN). A DPN makes the director personally liable for the company's unpaid PAYG withholding and superannuation debts.

The Importance of a Formal Employment Agreement

Even for a sole director and shareholder, preparing a formal employment agreement is a sound governance practice. The document codifies the employer-employee relationship and provides legal clarity.

A comprehensive agreement should specify:

• The director’s job title and responsibilities.

• The agreed-upon salary and payment frequency.

• Entitlements such as leave and other benefits.

• Procedures for salary reviews.

This documentation is valuable during an ATO audit or legal dispute, as it provides clear evidence for the nature of the payments. For businesses in Brisbane and throughout Australia, establishing this structure from inception helps avoid ambiguity and strengthens corporate governance.

The distinction between director drawings, salaries, and dividends carries significant tax consequences and is an area the ATO frequently scrutinises. When a director takes funds as 'drawings' instead of a formal salary, the company cannot claim a tax deduction and fails to meet its PAYG withholding and superannuation obligations—a compliance failure that can trigger an audit. Government reports on business classifications can provide deeper insights into regulatory views.

Understanding Dividends as a Profit Distribution

Unlike a salary, which is remuneration for work, a dividend is a return on ownership. It is a mechanism for a company to distribute its after-tax profits to its shareholders, compensating them for their capital investment and risk.

This distinction is fundamental to why the correct classification between salaries, dividends, and director drawings is critical for tax compliance.

Australia's dividend imputation system is designed to prevent company profits from being taxed twice—once at the corporate level and again at the shareholder level. The key component of this system is the franking credit.

The Role of Franking Credits

A franking credit represents the amount of Australian company tax already paid on the profits being distributed as a dividend.

When a shareholder receives a franked dividend, they receive both the cash payment and the attached tax credit. On their personal income tax return, they must declare both the dividend amount and the franking credit as assessable income. The credit then acts as an offset, reducing their final personal income tax liability.

For a detailed analysis of the calculations, refer to our guide on how to calculate franking credits in Australia.

Corporate Governance for Declaring a Dividend

A dividend cannot be an informal transfer of funds. For the ATO and ASIC to recognise it as a legitimate dividend, the company must follow a formal, legally mandated process.

Key Procedural Steps: 1. Confirm Distributable Profits: The company must have sufficient retained earnings (accumulated after-tax profits) to cover the dividend payment. It is unlawful to pay a dividend if it would compromise the company's solvency. 2. Director's Resolution: The directors must convene a meeting and pass a formal resolution to declare the dividend, specifying the amount per share and the payment date. 3. Documentation: This resolution must be recorded in the company’s official minute book, creating a legal record of the decision. 4. Payment and Statement: The company pays the dividend and provides each shareholder with a dividend statement detailing the cash amount, the attached franking credit, and the franking percentage.

These steps are mandatory requirements under the Corporations Act 2001. Omitting them could lead the ATO to reclassify the payment, potentially as an unfranked dividend or a loan, which may result in adverse tax outcomes.

Brisbane-Based Example: Dividend Declaration

Consider a small IT consultancy in Milton, a suburb of Brisbane. It is a base rate entity subject to the 25% corporate tax rate. The company decides to distribute a $15,000 fully franked dividend to its sole director-shareholder.

The process is as follows:

• The company generated $20,000 in pre-tax profit and paid $5,000 in company tax (25% of $20,000), leaving $15,000 in after-tax profit available for distribution. The $5,000 tax payment generates the franking credit.

• The director receives $15,000 cash.

• On their personal tax return, the director declares a "grossed-up" income of $20,000 ($15,000 cash + $5,000 franking credit).

• Personal income tax is calculated on the full $20,000, and the $5,000 franking credit is used to offset the final tax payable.

This process is relevant for thousands of Brisbane SMEs. ATO compliance activities often identify instances where profit distributions are misclassified as drawings, preventing the use of franking credits and potentially leading to overpayment of tax.

Navigating the Dangers of Director Drawings and Division 7A

Taking a 'drawing' from the company account may seem like a straightforward way to access funds. However, this apparent simplicity conceals a significant tax integrity measure for private company directors: Division 7A.

From the ATO's perspective, a director drawing is not an informal withdrawal; it is a loan. This classification immediately engages a complex set of anti-avoidance rules designed to prevent directors from extracting company profits tax-free.

What Is Division 7A and Why Does It Exist?

Division 7A of the Income Tax Assessment Act 1936 functions as a regulatory control over financial benefits provided by private companies to their shareholders and their associates. Its primary purpose is to ensure that all distributions of company profit are appropriately taxed.

The legislation prevents business owners from using company funds for personal use indefinitely through "loans" or "drawings," which would otherwise circumvent PAYG withholding on a salary or the tax implications of a dividend.

ATO's Core Principle: If a payment from a company to a shareholder has the character of a profit distribution, it should be taxed as such. Division 7A is the mechanism that enforces this principle.

The Consequence of a "Deemed Dividend"

If a director's loan account is not managed in compliance with Division 7A, the ATO can reclassify the loan amount as a "deemed dividend." This is a punitive measure with significant financial consequences.

A deemed dividend is treated as unfranked. This means the shareholder receives no credit for the tax the company has already paid on its profits. The full loan amount is included in the director's assessable income for that year and taxed at their marginal tax rate. This effectively results in double taxation: the profit was taxed once within the company, and it is taxed again in the shareholder's hands without any offset.

The Division 7A Trap Visualised

The following diagram illustrates a common compliance failure scenario for directors in Brisbane and across Australia.

      Step 1: Informal Drawing
          │
          └──> Director withdraws $50,000 from the company for personal use.
               (No salary is processed, no dividend is declared. It is recorded as a "drawing.")

      Step 2: End of Financial Year
          │
          └──> The Director Loan Account reflects a debit balance of $50,000.
               (This is now considered a loan by the ATO.)

      Step 3: Division 7A Trigger
          │
          └──> No compliant loan agreement is in place.
               No minimum yearly repayments of principal and interest are made.

      Step 4: Deemed Dividend Assessment
          │
          └──> The ATO deems the $50,000 to be an UNFRANKED dividend.
               The director's personal assessable income increases by $50,000.

How to Correctly Manage a Director's Loan

Division 7A also provides clear pathways for compliance. If a director's loan exists, there are specific actions that can be taken to avoid a deemed dividend assessment.

• Repay It in Full: The most direct solution is to repay the entire loan balance to the company before the company's income tax return lodgement day for that financial year.

• Establish a Complying Loan Agreement: The loan can be formalised under a written agreement that meets all Division 7A requirements. This includes a minimum interest rate (based on the ATO’s benchmark rate) and a maximum loan term (7 years for an unsecured loan, or 25 years if secured by a registered mortgage over real property).

• Declare a Dividend to Offset the Loan: The company can declare a formal, franked dividend to the shareholder. The dividend amount can then be used to reduce or clear the outstanding loan balance instead of being paid in cash.

Correctly managing director loans is a critical responsibility.

A Side-by-Side Look at Your Options

For a company director, determining the optimal method for withdrawing funds involves more than a simple cash transfer. Each method—salary, dividends, and drawings—establishes a distinct financial and legal position for both the director and the business.

This section provides a comparative analysis to clarify the practical implications of each choice on the company's financial standing and compliance obligations.

Comparing Salary, Dividends, and Director Drawings (FY 2025–26)

This table outlines the key tax, superannuation, and compliance differences between the three primary methods of director remuneration.

Attribute	Salary	Franked Dividend	Director Drawing / Loan
Company Tax Deductibility	Yes - The gross salary and superannuation are deductible expenses, reducing company profit.	No - Dividends are a distribution of after-tax profits and are not deductible.	No - Drawings are treated as loans and are not a deductible business expense.
Superannuation Guarantee	Mandatory - The company must pay 12% of ordinary time earnings as SG contributions.	Not Applicable - Dividends are not ordinary time earnings, so no super is payable.	Not Applicable - As a loan, no superannuation obligations are triggered.
PAYG Withholding	Mandatory - Tax must be withheld and remitted to the ATO via Single Touch Payroll.	Not Applicable - No tax is withheld from the dividend payment itself.	Not Applicable - No withholding is required as it is not an income payment.
Primary Compliance Risk	Director Penalty Notice (DPN) risk for unpaid PAYG withholding and superannuation.	Incorrect documentation (e.g., no director's resolution) or declaring an unlawful dividend.	Triggering Division 7A, resulting in an unfranked "deemed dividend."

Brisbane Business Case Study

Consider a Brisbane-based marketing agency, "Fortitude Valley Creative Pty Ltd," a base rate entity with a 25% corporate tax rate. The sole director, Alex, requires $88,000 for personal expenses. For simplicity, this example ignores the tax-free threshold to focus on the mechanics.

Scenario 1: Alex takes an $88,000 Salary

• Company Impact: The company pays Alex a salary of $88,000. It must also contribute $10,560 (12% of $88,000) to Alex’s super fund.

• The total cost to the company is $98,560, all of which is a tax-deductible expense, reducing the company's taxable income by that amount.

• Alex's Impact: Alex receives $88,000 in assessable income (less tax withheld) and $10,560 in superannuation contributions.

Scenario 2: Alex receives a Franked Dividend

• Company Impact: To pay an $88,000 cash dividend, the company must first generate $117,333 in pre-tax profit. It then pays $29,333 in tax (25%), leaving the $88,000 post-tax profit for distribution. The $88,000 dividend payment is not tax-deductible.

• Alex's Impact: Alex receives $88,000 cash and a $29,333 franking credit. Alex declares a grossed-up income of $117,333 and uses the credit to offset their personal tax liability. No superannuation is paid.

Key Takeaway: The dividend option requires the company to generate significantly more pre-tax profit ($117,333) to deliver the same $88,000 cash to the director compared to the salary option.

Scenario 3: Alex takes an $88,000 Director Drawing

• Company Impact: The company's cash decreases by $88,000, creating a loan receivable from Alex. This transaction is not a tax-deductible expense. The company must resolve this loan before its tax lodgement deadline to avoid Division 7A penalties.

• Alex's Impact: Alex has the $88,000, but it is a debt owed back to the company. If not managed compliantly, the ATO can deem the $88,000 to be an unfranked dividend, adding it to Alex's taxable income without any franking credits. This would result in a substantial and unforeseen personal tax liability.

In summary, while a drawing may appear simplest, it carries the most severe compliance risk. The decision between a salary and dividends is more strategic, depending on the company's profitability, the director's personal tax circumstances, and long-term financial planning objectives.

Summary

Key Compliance Requirements

• Salary: Must be processed through Single Touch Payroll (STP), with PAYG tax withheld and superannuation contributions made. A formal employment agreement is recommended.

• Dividends: Must be declared by a formal director's resolution, recorded in the company minute book, and paid from sufficient retained (after-tax) profits.

• Director Drawings: Must be repaid in full before the company’s tax lodgement day or be placed under a complying Division 7A loan agreement to avoid being treated as an unfranked deemed dividend.

Risk Areas

• Personal Liability: Directors face personal liability for the company's unpaid PAYG withholding and superannuation via Director Penalty Notices (DPNs).

• Division 7A: The primary risk associated with director drawings is the automatic classification of the loan as an unfranked deemed dividend if not managed correctly, leading to double taxation.

• Insolvent Trading: Declaring a dividend when the company does not have sufficient retained profits can be a breach of director's duties and may constitute insolvent trading.

Brisbane-Relevant Considerations

• For Brisbane-based small and medium enterprises (SMEs), which form a significant part of the local economy, maintaining clear distinctions between company and personal funds is critical for sustainable growth and compliance.

• Variable cash flow in service-based industries common in Brisbane can increase the temptation to use informal drawings. Meticulous bookkeeping is essential to correctly classify every transaction from the outset.

Official ATO Reference

For further verification of the rules regarding payments from private companies, refer to the ATO's guidance on Division 7A.

• Division 7A - loans by private companies: https://www.ato.gov.au/businesses-and-organisations/corporate-tax-measures-and-assurance/private-company-benefits-division-7a-dividends/in-detail/division-7a-loans

Situation-Based Considerations

The information presented in this article is for general educational purposes and does not constitute financial or legal advice. The optimal strategy for director remuneration depends on a range of factors specific to your company's financial position, its tax profile, and your personal circumstances.

Outcomes can vary significantly based on these variables. Before finalising any remuneration strategy, it is prudent to seek a professional review from a qualified tax advisor or accountant who can provide guidance tailored to your specific situation. This ensures your decisions are both tax-effective and fully compliant with Australian law.

For further official guidance, please consult the following resources:

• Australian Taxation Office (ATO): www.ato.gov.au

• Australian Securities & Investments Commission (ASIC): www.asic.gov.au

Director Remuneration FAQs

Can I pay myself a combination of salary and dividends?

Yes. This is a common and often effective strategy. A director may receive a regular salary to ensure consistent income and meet superannuation obligations. Subsequently, after the company's annual financial performance is determined, a dividend can be declared to distribute a portion of the profits. This hybrid approach combines the stability of a salary with the flexibility of a profit-based distribution.

What happens if my director loan account is overdrawn at year-end?

An overdrawn director loan account is a significant compliance issue for the ATO as it triggers Division 7A. If the loan is not fully repaid before the company's tax return lodgement deadline, the ATO will likely treat the entire overdrawn amount as an unfranked "deemed dividend." This amount is then added to your personal assessable income without any offsetting franking credits, which can result in a substantial personal tax liability. To resolve this, you must either repay the loan in full, declare a dividend to offset the balance, or enter into a formal, compliant Division 7A loan agreement.

Do I have to pay superannuation on director's fees?

Yes. The ATO considers director's fees to be ordinary time earnings (OTE). Therefore, the company is obligated to pay the Superannuation Guarantee (SG) on these fees. For the FY 2025–26, the SG rate is 12%. Failure to pay superannuation on director’s fees constitutes a breach and can result in the Superannuation Guarantee Charge (SGC), which includes penalties and interest and is not tax-deductible.

Can I take drawings if my company is not yet profitable?

While it is physically possible, it is a high-risk practice. Taking a drawing from a company with no retained profits means you are borrowing against the company's share capital, not distributing profit. This action creates a director's loan that you are legally obligated to repay. If the company were to become insolvent, a liquidator would likely seek to recover this loan from you personally to satisfy creditor claims. This can also be considered a breach of your director's duties. A modest, formal salary is a more compliant and safer approach in such circumstances.

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