NZ income tax – business vs personal (part 1!)

Kia ora Kiwi readers! We’re back with more tax tips.

There tends to be quite a bit of confusion between business taxes and personal taxes when it comes to income tax. In today’s article we’re going to look at the differences and relationship between business and personal tax.

Note that we’re only focusing on INCOME TAX for this article. Income tax is the tax that you pay on your income. We’re not going to touch GST, FBT, PIR or FIF (or any other tax acronym that you can think of). We’re looking only at Income tax and how businesses and individuals calculate it. Also – tax advice contained in this article is relevant only to New Zealand. If you’re outside of this jurisdiction, please consult with your local tax advisor.

Income tax – how does it work?

Income tax is the most common tax type in NZ. Every tax-paying entity has to declare income tax (in some form). Employees on a PAYE salary don’t have to worry about calculating income tax. Their employers do it for them. The income tax they pay is then deducted from their gross wages. How much tax is taken depends on the tax code that they use.

Businesses have to calculate their tax themselves. Or you can use accounting software like HNRY to automate this for you (please note you still have to manually key in expenses and it only works for sole traders). Then they pay this tax directly to the IRD. Most business owners find tax stressful. Which is why they turn to accountants to sort out their taxes for them.

Calculating personal income tax

IRD uses tax brackets to calculate your personal income tax. Please read this article for more information on how it works. The gist of it is that, the more income you make, the more tax you pay proportionate to your income.

As of 29 October 2023, these are what the tax brackets look like for individuals:

Income is taxable based on the brackets they fall into. For example, if you’re making $60,000 a year, you are paying 10.5% tax on the first $14,000. The next $34,000 falls within the 17.5% bracket (over $14,000 and up to $48,000). The remaining $12,000 falls in the 30% bracket (over $48,000 and up to $70,000).

You’d be paying tax of $11,020 in total. This is an effective tax rate of 18.37% ($11,020/$60,000 X 100). The breakdown looks like this:

Contrary to popular belief, you’re NOT paying tax on all your income at 30% if you’re in the 30% bracket. Income is taxed based on the bracket that they fall into. As per the example above, if you’re making $60,000 a year (gross) you’re only paying 18.37% of your income as tax.

What constitutes personal income?

Surprisingly, a LOT of things constitute personal income. Here is a (non-exhaustive) list of income sources that can get added to your personal income:

1. Salaries (Gross amounts)
2. Residential rental income (which also includes AirBnB/short term rentals and fees from boarders)
3. Dividends received from shares
4. Proceeds from property sales (if within the bright-line test)
5. Income from business (sole trader business)
6. Income from overseas (you may claim foreign tax credits on this if you’ve been taxed at source)

And much more. Basically, any income you receive is (very likely) taxable as part of your personal income. So let’s use the earlier example of $60,000 as a baseline salary income. If you’re making another $20,000 from your AirBnB, then this $20,000 adds to your $60,000 from your salary for a total personal income of $80,000. Now your taxes look like this:

Now your effective tax rate jumps to 21.65% ($17,320/$80,000 X 100). The additional $20,000 you made from your AirBnB is taxed at the 30% and 33% tax bracket ($22,000 at 30% and $3,300 at 33%). Hence the more money you make, the more tax you proportionately pay on that amount.

Can I claim deductions against my personal income?

It depends on the source of income.

There are only a few things that you can claim against PAYE income. These are:

1. Expenses paid to a tax professional/accountant
2. Income protection insurance
3. Interest on loans taken out for investments
4. Commission charged on income from interest investments
5. Interest paid to the IRD on late payments.

It’s a whole different story if you are a business owner!

Business income tax (as a sole trader)

If you’re starting off as a business owner (or self-employed contractor), you’ll likely start as a sole trader. This is because a sole trader is a cheap and easy way to start a business. As a sole trader, all profit that you make from your business is reported in your personal name.

Your profit is calculated based on your sales minus your expenses. For example, if you’ve made sales of $30,000 this year and all your expenses add up to $20,000. You’ve got a net profit of $10,000. This $10,000 is added to all your other sources of personal income and this may bump you up a tax bracket.

What sort of expenses can I claim as a sole trader?

Everything that you could on a PAYE salary and then some! Here is an inexhaustive list of expenses you can claim:

1. Cost of goods sold (if you’re in retail)
2. Advertising costs
3. Rental
4. Equipment hire
5. Software subcriptions

And so much more! If in doubt, you can check out this article on what is a business expense.

What if I make a loss as a sole trader?

Losses are treated as negative income. This happens when you have more expenses than sales. Losses made as a sole trader reduce your overall income. For example, you make sales of $30,000 and expenses of $40,000. This is a loss of -$10,000. This will reduce your other sources of income and can potentially drop you a tax bracket.

It’s quite natural to be making a loss when first starting a business. However, please be warned that if you are consistently reporting losses to the IRD over several years – you may be investigated for tax avoidance! Always remember to keep a record of your business expenses and have a plan to run your business as a profit making entity.

Do I pay less income taxes if I started a company?

The answer is: It depends.

I often encourage clients to start off as sole traders and then start a company once certain income thresholds have been met. Also there are a host of other factors (apart from tax) that come into play when deciding whether to start a company.

If you want a run down of the differences between a sole trader setup and a company, check out this article.

Let’s take a closer look at what it means to pay tax as a company in part 2 of this series!

In the meantime,

Stay positive!