What is the best way to pay yourself from small business profits?

This post is by Giles Ellis, Director at GECA Chartered Accountants based in Newmarket.

It’s often said we are a nation of entrepreneurs and statistics back that up with more than 100,000 businesses in Auckland alone.

If you are one of those hard working and smart Kiwi entrepreneurs, it’s likely you set up a business and after trading profitably for a period of time, want to extract some of those profits. This, however, is not as easy as you might think and there are several traps for the unwary that can add additional and unnecessary taxes.

The best way to pay yourself from small business profits:

Business owners using a limited liability company have a number of options for paying profits, each with their own pros and cons.

1. Pay yourself a dividend

This should be done where there are sufficient Imputation Credits available to attach to the dividend to avoid double taxation, once by the company and once by the recipient of the dividend. Imputation credits are generated when a company pays tax with $1 Imputation credit available for each $1 of tax paid so provisional and terminal tax payments will generate imputation credits.

The issue here is the company is required to pay an additional 5% of RWT on the payment of a dividend regardless of the personal tax rate of the shareholder.  If shareholder’s personal tax rate is lower than 28%, the credit cannot be refunded although it can be rolled over to the following year.

However, if the shareholders only income is from dividends, effectively they will never get to use the excess tax credits and the shareholder will have paid too much tax via the company.

2. Pay a regular salary and deduct PAYE

This way tax is paid as income is earned. However, if the actual profit for the year turns out less than what was budgeted for and the salary paid puts the company in a loss position, then excess tax is paid by the shareholder on the salary and the company has a tax loss.

3. Take drawings during the year and then after the tax year ends, determine the company profit and pay that out as a shareholder salary

If there is shortfall between the shareholder salary paid and drawings taken the shareholder may owe the company at year end. For tax purposes, this is treated as a loan to the shareholder and interest must be charged on it. This results in interest income to the company subject to tax but with no deduction for the interest paid by the shareholder.

Also note that a shareholder salary cannot be paid if the shareholder has received any salary throughout the year with PAYE deductions.

There is also the option to set up a Look Through Company (LTC) which treats the income and expenses as being derived by the shareholder rather than the company. This means tax is paid at the shareholders marginal rate rather than the company tax rate, which at the top band of 33% is higher than the company tax rate of 28%.

There is also a significant compliance cost to administer an LTC and there can be tax implications when liquidating the LTC.  Due to this, LTCs are only suitable for certain types of business activities.

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As you can see, there is no one best way to pay yourself from small business profits, it can be done in a number of ways and the consequences can be costly if not done right.

Want the right advice for your circumstances? You can learn more about GECA’s range of taxation and accounting services here, or if you’d prefer to speak to an adviser, call now on 0800 758 766.