(business tax – 5 minute read)
Hi Accounting fans!
We’re back with part 2 of the NZ income tax article. In case you missed the first one, you can read all about personal income taxes right here!
In the previous article we spoke more about personal income tax. Specifically, looking at the different income types that get bundled together to form your taxable income.
This time around we’re going to change tack. Let’s talk about business tax!
Is business tax in NZ different from personal income tax?
Yes and no. Which is probably not the most direct answer!
Let’s establish a ground rule first: Regardless of your business structure, you are always taxed on your taxable profit. Your taxable profit is always your Sales Revenue minus your tax deductible expenses. The lower your profit, the less taxes you pay. And vice versa.
If you are a sole trader, your profit gets combined with personal income from all other sources (including PAYE). As mentioned in the previous article, this means that if you make a loss, you may end up offsetting your other income sources as well.
If, on the other hand, you own a company, well then tax becomes A LOT more complicated.
How does business tax work?
I’m going to contradict myself and say: It’s really simple (haha).
You pay a flat 28% tax on all profit generated by your company. Easy right?
Not exactly.
Let’s start with the basics:
Shareholders own the company. Shareholders are separate legal entities from the company. Most small businesses only have one shareholder. This shareholder is usually the same person who runs the business daily. Sometimes it’s a romantically attached couple that run the business together (I.e. – husband and wife).
Depending on the overall business situation, you can choose to pay yourself (as the shareholder) a shareholder salary. This shareholder salary is an expense that reduces the overall profit of the company.
Wait, what is a shareholder salary??
*breathes in*. Now company tax gets tricky.
We’ve written about shareholder salaries in the past. Here’s the breakdown:
Every shareholder maintains what is known as a ‘shareholder current account’. This is an account that sits in your company and it mainly keeps track of:
- The money you put into the business (funds introduced)
- The money you take out of the business for personal use (drawings)
When you pay yourself from the business, you are taking drawings from the business. When you put money into the business (from your personal funds) you are introducing funds into the business.
How does shareholder salary fit in?
Typically, we want the current account to have a ‘credit’ balance – this means that the company owes YOU money. Not the other way around. In most cases, at the end of the financial year, the owner of the company will have taken more money out than what they put in (naturally). This puts the shareholder current account into a ‘debit’ balance – YOU owe the company money!
But aha! What about all the hard work that you’ve done for the company without (officially) getting paid? (Drawings are non-tax deductible and do not incur income tax for the individual drawing them). This is where shareholder salary comes in. By making an accounting declaration that you have paid yourself a shareholder salary (for all your hard work), you can eliminate the debit balance in your shareholder current account AND reduce the profit of your company (which reduces your taxes).
It’s important to note that no physical cash is actually paid to the shareholder with shareholder salary. Rather it is an accounting adjustment made to reflect the monetary value of the work performed by the shareholder for the company.
How do you calculate shareholder salary?
Time to expose some accounting industry trade secrets! Bwaha!
So most accountants will work out your shareholder salary based on a few factors:
- How much profit your company made during the financial year – shareholder salary is an expense. The amount we can declare is capped at how much profit the company has made (before shareholder salary obvs).
- What the balance in your shareholder current account is – typically we aim to get the shareholder current account into debit (or nil) balance. An overdrawn (over drawing – get it?) current account with a debit balance is frowned upon in the industry. A consistently (year on year) overdrawn current account may look like tax avoidance to the IRD, which we’ll talk about later.
- What the market rate for your work done for the company is – a contentious point. How does one value one’s work for one’s own company anyway? Most small business owners work 60+ hours a week and get very little in return. That being said, if you run a health clinic or are running a legal service, we will try our best to match the shareholder salary to what a similarly experienced professional in your field would be earning as an employee.
- Taxes – Welp. I wish I could write more about this but then I’d need to write a whole other article about tax structures and efficiencies. Also, if I’m not careful it may look like I’m teaching you how to avoid taxes (which is a no-no!). Suffice to say, if you have a different main income source (apart from your company), it may affect how much shareholder salary we declare in your name. If you run the business with other shareholders (like your significant other) this will also affect how much we declare in each of your names.
Calculation example
So for example, your company profits $30,000 in its first year. Your shareholder current account is $20,000 in debit balance (you owe the company). The market rate for your kind of work is typically $50,000 per annum. You don’t have any other sources of income.
In this example above, we would look to declare shareholder salary of $30,000 for the following reasons:
- You don’t have to pay any company taxes. $30,000 shareholder salary clears out your company profit. You don’t have to pay taxes at a flat 28% (which will be higher than your personal tax bracket)
- It clears the debit balance in your shareholder current account. This is always a good thing. You don’t owe the company anything.
- It shows the IRD that you’re trying to pay yourself your market rate (close enough). This signals that you are a good, honest, business tax paying person of Aotearoa. Ka pai!
- You pay tax on the $30,000 in your personal name. This means that shareholder salary gets calculated as part of your personal income tax. Your highest tax bracket is only 17.5%. Your total effective tax rate is 14.23% (heck of a lot lower than the 28% tax that you’d have to pay if you kept it as part of your company profit!)
But, wait, why do rich people use companies to pay less taxes then?
Ahah-hah. Where did you hear that from? Hope it wasn’t from me! Besides, all rich people pay their fair share of taxes! *sweats nervously*
But seriously, up to a certain point, you will pay less taxes through personal income tax. Once you’re making upwards of $200,000 a year in your personal name, only then does your effective tax rate hit 29% (this is mainly due to the 39% tax bracket for all income above $180,000). Assuming that your company has enough profit, not too much debit balance in your current account and you’re not grossly understating your contribution to the company (see: ‘market rate’ above). We would look at declaring a ‘reasonable’ amount of shareholder salary to show a true and fair view of your remuneration by the company.
This means that if you are the director of a small legal firm (for example) and you made profits of $200,000, with a debit balance of $100,000 in your shareholder current account. We would look at declaring shareholder salary of around $150,000 for you in that financial year. This captures market appropriate compensation for yourself and properly reflects the amount of funds you have retained in the business for capital growth purposes. This means that you pay taxes on the $150,000 in your personal name (at an effective tax rate of 26.9% and the remainder $50,000 remains in the company as profit and gets taxed at 28%).
In contrast, if you were an employee making $200,000 per annum, you’d have an effective tax rate of 29%. In other words, you’d be paying more in taxes than you would if you were running a company. IF you were making that much money.
So if I’m running a company, I have to worry about business taxes AND my personal taxes?
Exactly! But in doing so, it opens up a lot of opportunities for you to think about how to best deploy your business funds. Most company owners will opt to retain a certain amount of profit in the business for growth purposes (buying new assets, hiring new staff, etc.).
You can also declare an amount from shareholder salaries that matches up with what you feel your actual contribution to the company is. This allows for flexibility in determining what your personal income is at the end of the financial year. If your spouse is also a shareholder in the business, you can also declare some of the company profits in their name as shareholder salary to reflect their contribution to the business.
However, it is important to remember that you need to be able to justify the amounts of shareholder salary declared. What we’re doing here is basically splitting the profits across multiple entities (the company, yourself, your spouse) which, in practice, lowers your overall tax rate and can be construed as tax avoidance. Therefore, you should have proof of the work that you and your spouse has done for the company AND a plan (or just a really good reason) why you need to retain funds within the company (if you’re leaving some profit in the company).
Avoid tax avoidance!
IRD doesn’t like it when you make use of tax structures to game the tax system. Ideally, everyone should be paying their fair share of taxes. The key consideration is to show correct income attribution, proportional to the amount of work that you do for the company. This can be done by:
- Ensuring that shareholder salary is close to the market rate (profit allowing)
- Keeping the shareholder current account in credit balance. An overdrawn current account implies that you, the shareholder, are taking a lot of drawings for personal use but not declaring any shareholder salary to offset those drawings. This can look like you are avoiding paying taxes in your personal name.
- Ensuring that you have proof of work done for the company for every shareholder that is getting paid a shareholder salary. This can be as simple as emails sent, phone records and other forms of communications done between the shareholders and other stakeholders of the company.
Is there more to business tax?
Oh, heck yeah. What we’ve covered in this article is but the most basic understanding of how company tax works.
We haven’t even looked at trusts, look through companies, limited partnerships, dividend declarations, imputation credits, fringe benefit tax and withholding tax. There are a lot of different facets to business tax that we can’t cover them all in one article. But if you’re just starting your first company (or thinking of starting one), this article should be good enough to give you an overview of your future tax situation.
If you ever need specific tax advice, remember that you can always contact us right here and we’ll be more than happy to help you work out your finances and taxes.
Stay positive!