There are several options for drawing money from your owner-operated business and each has implications that are worth considering when weighing your options up. Applied correctly, you could potentially spread your tax obligations across the year, thereby reducing end-of-year terminal tax and provisional taxes and improving your cash-flows. Apply them incorrectly and you could get yourself into some trouble with the Companies Office or Inland Revenue. So, here we look at each of the options and their pros, cons and other issues to be aware of. As always, if you have any queries or need advice on the topic, please contact me. The material below is intended to inform and educate and should not be taken as a replacement for professional advice tailored to your particular situation.
Drawings
During the year, sole-traders, partners or shareholders may choose to take drawings. This is a cash transaction only and does not affect the business’s net profits. However, you need to be careful that you do not draw more than your share of net profit, otherwise this may put your equity or current account into an overdrawn situation. This is especially a problem for companies. Companies should consider charging interest on overdrawn current accounts, otherwise the company may become liable for Fringe Benefit Tax, or if the balance is long-outstanding or irrecoverable, there is a risk it could be deemed a dividend and taxed accordingly.
Shareholder Salary
Businesses generally allocate net profits to partners or shareholder salaries to shareholders. This is done at the end of the year, once net profits are known. For a company, a shareholder salary can assist you in legitimately reducing your overall taxes payable, as your personal tax rate (for the first $48k), will be lower than the company’s, and your personal tax rate on the first $70k is lower than the dividend tax rate. Shareholder salaries must be reasonable and reflect actual expertise / work performed / risk / investment in the company etc. Companies have a legal obligation to ensure the company continues to have positive equity, so the total of all shareholder salaries for the year should not normally exceed the net profits of the company.
Wage/Salary
Partners/shareholders can choose to take a wage or salary during the year. This may replace, or partly replace drawings. As PAYE is being deducted from your wage/salary, this reduces your year-end taxes, and also reduces (or in some cases, eliminates) provisional tax. This can be an excellent solution for managing taxes and cash-flows. However, there are several issues to be aware of:
- You should have a formal written employment contract in place. Even if this means that you sign it both as employer/director/partner and also as employee. This provides evidence of the arrangement and sets out the terms and remuneration.
- You need to complete and sign an IR330 (tax code declaration).
- The wage/salary should be realistic. It cannot be much higher or lower than you would expect to earn doing the same work for someone else.
- The wage/salary cannot normally be increased or decreased in line with profits. However, I see no issues with building a quarterly or annual bonus into the agreement, so that if you are performing well (and therefore profits are higher than expected), you can take a bonus. The amount and frequency of the bonus and the conditions to be met should be stated in the employment agreement.
- Your wage/salary (plus any drawings taken on top of this) should not normally exceed your share of net profits for the year.
- You (or your accountant) need to keep records of wage calculations, any bonuses, deductions, payments etc.
- You (or your accountant) need to file monthly PAYE returns with IRD and pay the PAYE due.
For these reasons, paying yourself a PAYE-deducted wage or salary can work extremely well if your business generates relatively stable, consistent net profits, if you are comfortable with calculating wages and PAYE and if you are happy with the level of documentation you need to have in place. It can however be quite risky for businesses with fluctuating performance or for businesses whose net profits are on the decline.
If you go to the trouble of calculating a wage or salary and deducting and paying PAYE, you might just as well join Kiwisaver while you’re at it. Although there is no longer the $1,000 kick-start payment, you will still receive employer contributions and the annual member tax credit. You would need to complete and sign a KS2 and calculate Kiwisaver deductions and contributions when you calculate your wage/salary and include employee deductions and employer contributions in your PAYE returns.
Dividends
Dividends are taxed at the flat rate of 33%, which is also the highest individual tax rate, so there is no overall tax benefit to issuing dividends, compared to a wage, salary or shareholder salary. However, they may be appropriate if your company has net profits from previous years not yet allocated to shareholders and therefore also a balance in its imputation credit account (ie taxes paid by the company on profits not yet allocated to shareholders).
In practice, this generally involves the company paying the company tax rate of 28% on net profits, then issuing a dividend to shareholders with imputation credits attached (resulting from the 28% tax paid) and then the company pays a further 5% resident witholding tax (to bring tax paid on the dividend up to 33%). Dividend witholding tax must be paid to Inland Revenue by the 20th of the following month.
Although the recipient shareholder will not have to pay further taxes on a “fully imputed” dividend, the credits cannot however be used to reduce your overall individual income tax liability (ie, they cannot be applied to other taxable income), however the dividend witholding tax can.
There is no ACC earner levy on dividends, whereas there is on a wage, salary or shareholder salary, which means that while you won’t be paying the ACC earner levy on this income, it also means that this portion of your income will not be covered in the event of an ACC claim.
Imputation credits cannot be carried forward (or applied to a dividend) if shareholder continuity is less than 66% from the time the company taxes were paid until the time the taxes (imputation credits) were attached to the dividend. If you have a balance in your imputation credit account and anticipate making significant changes in the company’s shareholding, it may be worth considering issuing a dividend to get the full benefit of the credits first.
It is worth noting that in order to issue a dividend, you must be sure that the company will be solvent both before and after the issue and the directors must complete and sign a Certificate of Solvency to this effect.
Summary
Profit allocations, shareholder salaries and dividends are determined or declared after net profits are calculated. They essentially (or hopefully…) cover any drawings taken during the period.
Profit allocations and shareholder salaries are not taxed until after your income tax returns are filed, however provisional tax (or an IRD assessment if you filed late) may be payable in the mean time.
Profit allocations and shareholder salaries are included in your individual income tax return and taxed at your marginal rate, which for the first $48k is lower than the company tax rate and for the first $70k, is lower than the dividend rate.
Company dividends provide a nice bonus in that the company pays the tax (terminal and possibly provisional tax), but the shareholders get the benefit of the company taxes paid in their individual tax returns. You cannot have the imputation credits refunded or offset against tax liabilities arising from other income, but you can with the dividend RWT. Dividends are not worth considering if your individual taxable income is $48k or less for this reason.
If you can handle the paper-work and record-keeping (or if you are happy to pay someone to do it, or perhaps you already employ staff anyway), and your business has relatively stable, consistent income, paying yourself a PAYE-deducted wage or salary can ease cash-flows and reduce your terminal and provisional tax liabilities. Any net profits left after the wage or salary is deducted will still be allocated to partners, or be available to distribute as shareholder salaries or dividends.
The above information is current at the time of writing and is provided in general terms only, relevant to owner-operated businesses in New Zealand. We do not accept responsibility or liability for its accuracy or for the outcomes that may result from placing reliance on this information. If you have any queries about the tax implications of your drawings, distributions or profit allocations, please feel free to contact me so I can take any subsequent legislative changes and your particular circumstances into account.
Amanda Imms CA
Principal
AJ Accounting Limited
ph. 021 771 557
amanda@ajaccounting.co.nz
