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February 6, 2017

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Salary or Drawings?

February 6, 2017

When you run your own small company there are a lot of things to take into account. One of these considerations is how you will pay yourself, with a PAYE deducted salary or will you just take drawings from the company?

 

This is an issue that we field questions on weekly. The answer is not simple and there are good and bad things about both of the options. Below we cover a few of the common considerations in broad strokes. For tailored advice, speak with your accountant or business advisor.

 

Salary with Pay-As-You-Earn (PAYE) Tax

Having a relationship with your own company as a shareholder, director and employee can mean that you are wearing many different hats everyday. This is especially evident when and if you decide to employ yourself and pay yourself a fixed wage or salary. As your company is a separate legal entity, you (as the director of the company) will need to offer yourself (as an employee) a contract for employment and sign this individual employment agreement in order to comply with the law.

 

If you decide to pay yourself a fixed salary, just as if you were an independent employee with your company, you will pay the tax on your income as you earn it throughout the year. The appropriate taxes are deducted from each pay run and paid to the IRD monthly along with the filing of the PAYE Return. This option breaks your tax liability up into bite sized monthly payments and can allow for much easier planning of your company cash flow as your tax bill will be the same every month (unless you give yourself a raise).

 

Having a fixed income from a salary will also mean that you have a declared salary for ACC purposes. The appropriate levies for ACC will be deducted as a part of your PAYE payments, ensuring that you are always up to date with levy payments and have a certain level of income should you have an accident and need to make a claim.

 

Ease with ACC is not the only benefit of a fixed salary, you may also have an advantage if you are trying to personally raise funds, such as a mortgage. In most cases, it will be easier to borrow a mortgage if you have a regular income rather than if you are living off the profit generated by your company (drawings). If you are living off drawings, many financial institutions require at least two years worth of financial statements when considering your application.

 

One of the downsides of paying a fixed salary is that you may end up with a bigger overall tax bill than you would with drawings. This is especially true in the formation years as many businesses run at a loss in these early phases and have minimal tax liabilities. A loss generated by your company would not mitigate any tax on your salary. Drawings offer much greater flexibility in allocating exactly what you and your company and afford and has the ability to structure payments for the greatest tax advantage (within the limitations of the income attribution rules).

 

Drawings and Shareholder Salary

An alternative to paying yourself a fixed salary is to live off drawings from the company throughout the year and then allocate a shareholder salary at year end. Ideally, the entire amount of your drawings throughout the year will exactly equal your allocated shareholder salary. The main advantage of this method is that it allows you the benefit of hindsight and to maximise your personal and company tax benefit at year end based on the actual financial performance of the company.

 

It is important to draw out lump sums as drawings from the company into your personal accounts (like a salary would be paid) rather than to start paying personal expenses direct from the company. Having too much cross over between your personal and company finances can lead to difficulties down the line if the company gets into any legal troubles and could lead the IRD to make an argument to pierce the veil of incorporation and leave you with none of the legal benefits or protections of the company structure.

 

To use drawings instead of a salary with monthly PAYE payments you will need to be disciplined in your drawings and plan for upcoming Provisional and Terminal Tax payments. The tax on your shareholder salary will be paid in three or four installments throughout the year as opposed to monthly with a PAYE salary. Having a cashflow forecast in place at the start of each financial cycle as well as a strategy to save for all taxes will help to mitigate any last minute panic as big lump sum tax payments become due.

 

Any drawings that you take during the year will be your income for ACC purposes and may be inadequate. This can be mitigated by opting for ACC Cover Plus or by having Income Protection Insurance with set weekly payments. MBP strongly advises our small business clients to consider their insurance options and to speak to a professional about policies such as Income Protection and Key Person insurance. Please get in touch if you would like us to put you in touch with a trusted advisor who can assess your needs and help you get the best cover at an affordable rate.

 

All or Nothing

It needs to be noted that if you opt for a PAYE salary, it is an all or nothing option. You are not able to have a salary one month and then switch back to drawings and then back to a salary. Once you are committed to the PAYE salary option for a particular income year you must deduct PAYE, period. You will have a contract for employment with yourself and will be in breach of that contract if you stop paying yourself for the work you do. If in doubt, ask for advise before doing anything.

 

Working shareholder salaries are a complex issue for all small businesses. There are a number of things that need to be taken into account from taxes to income attribution rules and tax avoidance measures. We recommend that you get in touch with your accountant or business advisor for guidance before making any final decisions.

 

This advice is general in nature. Every situation is unique and requires tailored advice. MBP have the expertise to help you make informed decisions about your salaries and payroll tax options. MBP Payroll Assist is an affordable monthly package that offers affordable payroll software, support and return management so that you can focus on your business and spend your down time doing the things you love. Get in touch for a free consultation by emailing mailbox@mercerbp.co.nz or call us on (07) 378 6655.

 

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