Disclaimer: This article is intended to be a plain English, introductory guide for Small and Medium Business Owners of New Zealand on what to consider when paying yourself. Everyone's financial situation, business cashflow, and goals are different so treat this as a starting point only. For tailored advice specific to your unique situation, please contact us at [email protected].
To keep things simple, some details have been generalised and technical points left out. Always check with your accountant about how these principles apply to your situation.
While running your own business gives you freedom, it creates one big question almost everyone struggles with:
"how do you get the business profits out of your company’s bank account and into your personal bank account so you can pay your mortgage and buy your coffee?"
If you take it all, will Inland Revenue come knocking? If you leave it all, how do you eat? And what on earth is a ‘drawing’ anyway?
This article is a plain-english, introductory guide to the 3 ways kiwi company owners pay themselves, and some common tax traps.
For company owners, there’s only really three options to choose from, pay yourself a PAYE salary, take drawings, or use a combination of both.
With a PAYE salary, you pay yourself exactly the same way you would any other employee. You register a Payroll account with Inland Revenue, you file payroll information every payday, you pay yourself an after tax wage into your personal account, and pay payroll tax and other deductions to Inland Revenue every month. It’s also impossible to exactly predict how much profit you’ll make in a year, so setting an amount in advance is quite the challenge.
The benefits of this is that it’s straightforward, and consistent.
The drawbacks are that you have to file returns every payrun, if the cashflow of the business is inconsistent, then the company might not have enough cash to pay you, and you can get some funky tax outcomes, especially if the salary you set for yourself is higher than the profit the company makes.
Drawings are simply transferring money from the business to yourself. At the end of the year, your accountant declares you a shareholder’s salary to cover what you’ve drawn + a few other technical considerations.
The benefits of taking drawings is that it will probably be the most tax efficient option, and you can easily adjust the amount you draw based on the cashflows of the business and your personal needs.
The drawbacks are that you’ll need to set aside money for tax since it’s not being paid as you go, and there’s a trap you can fall into, which is if you draw more than the business makes in profit, then you’ll find yourself owing the business money - which has some bad tax consequences.
Using a combination of both means that you pay yourself a PAYE salary, but you set it to what you know the business can sustain, and then top up with drawings as the business allows.
So lets, see some examples and the tax outcomes:
To use a nice round number, let’s say your business earns $100k of profit before tax and your pay in a year.
If you’re using the drawings method, then you’ll have taken out cash as you’ve gone, and since you’re a good business owner, you’ve also set aside between 25% and 40% for tax and ACC in a separate interest bearing bank account, depending on how profitable and conservative you are. When we do your financial statements and tax returns at the end of the financial year, we allocate you some or all of the company’s profits depending on quite a few technical factors, as well as considering the tax outcomes.
If you’ve got a crystal ball and managed to pay yourself a PAYE salary of exactly $100k, then you’ll have paid the $22,900 in PAYE plus other payroll deductions.
If you don’t have a crystal ball, you might have set yourself up to be paid $80k or $120k. What happens then?
The $80k scenario is essentially the combination method. There’s $20k of taxable profit left over and you’ll have paid $16,300 of PAYE plus other payroll deductions. The $20k could be kept in the company as retained earnings, meaning it’ll be taxed at the flat company tax rate of 28%, which is $5,600. That means the total tax expense between you and the company for the year would be, $21,900 a full $1k less than the PAYE salary option.
What about the $120k scenario? Now there’s $20k of losses, which are carried forward to be applied against the future profits. But you’ve already paid PAYE of $29,500 + other payroll deductions.
It’s starting to get quite complicated, because on the face of it, the $80k scenario has the best tax outcome, so you should just pick that one right? Well, not necessarily - the retained earnings will eventually need to be paid out as a dividend.
Dividends are taxable income for the shareholder, so if your marginal tax rate is above the company’s 28% tax rate in the tax year the dividend is declared, you’ll need to top up the tax. So, this can actually be the least tax efficient outcome of the 3 scenarios if your marginal tax rate is 39% because you’d have to top up the 11% difference between your 39% tax rate and the company’s 28% tax rate.
This is actually a really sneaky trap that I’ve seen a lot of accountants get wrong with their clients. They let the retained earnings of a company build up over the years, thinking that they’re giving their client a tax efficient shareholders salary between $53,500 and $180,000 and leaving the rest of the profit to be taxed in the company at 28%. They’re unwittingly creating a ticking timebomb of one big dividend that will be taxed at 39%, instead of having the client pay tax at 30% or 33% as the profit is made. Compounding this mistake is that the client often spends the cash as it’s earned, so when it comes time to do a wind-up dividend, the client doesn’t have the money to pay the top up 11%.
This might be you if you’ve been in business for a while. Take a look at your retained earnings figure in your last set of financial statements, if it’s above $100k, you might be in for a nasty tax surprise when you come to wind-up the company.
Paying yourself isn’t just about moving money around, it’s about keeping your business solvent, healthy, and stress-free.
Based in Dunedin, New Zealand, we offer free online consultations no matter where you’re based.
Take you first Step to get Ahead and click here to get a free instant estimate.
PAYE is a formal salary where tax is deducted monthly and paid to IRD. Drawings are simply transferring cash from the business to your personal account, with the tax calculated and paid at the end of the financial year (usually via provisional tax).
Yes, these are called drawings. However, if you take out more than the company makes in profit, you will overdraw your current account, which essentially means you owe the company money. This can trigger interest charges or Fringe Benefit Tax (FBT).