The current economic climate illuminates a couple of important truths: it is absolutely vital to ensure you take the right steps to organise your financial affairs and, irrespective of how large or small your operation is, the cornerstone of doing this is choosing the appropriate structure to operate with.
Taking the former first, there are a number of pretty simple steps that anyone should be mindful of as they organise their finances:
- Get GST registered. Most businesses, after all, turn over more than $40,000 per annum, which will soon become $60,000.
- Pay taxes on time. IRD charges credit card interest rates and penalties, which nobody wants to be paying even in the best of economic times. Although those rates are set to come down a little, they’re still an expensive line of credit.
- Put the right amount of money aside for income tax, GST and ACC – which is to say, approximately half of your gross income. Don’t make the mistake of spending it.
- Maximise your tax deductions. Get to know the expenses you can claim back.
- Use a professional. It’s a point that’s hard to over-emphasise. For one thing, the IRD trusts good professionals, and that’s bound to save you time and money in the long run. For another, it’s no less than anyone would do for any other important asset or activity – just as a good car deserves a professional mechanic, a good business also needs professional oversight.
That’s the straightforward stuff One of the more subtle areas that often trips up new ventures, especially contractors, is the attribution rule. That’s to say, if 80% or more of your income is earned from one source (business or public sector entity) during a financial year, then 100% of your profit is attributed to you personally, which usually means paying a majority of your tax at the highest personal tax rate of 39%.
What, then, are the available structural choices?
Sole trader: This, of course, is a person trading on their own. From a compliance perspective, it’s a cheaper option because you don’t have to complete annual financial statements. You do, however, still need to maintain all the financial records. It also leaves no room for tax planning, meaning you pay most of your tax at the highest personal tax rate.
Trading through a company with limited liability protection: A company is a legal entity in its own right, separate from its shareholders, and with its own unique tax obligations. Although the company tax rate has moved down from 33% to the more appealing-sounding 30% this tax year, this really means that, without a trust arrangement, you’re simply delaying your tax liability at the top rate and will duly be paying 39% on all income over $70,000.
Company with a trust ownership: This structure, which primarily provides for asset protection and wealth creation, offers a number of benefits, including tax minimisation (a secondary advantage but one that can be very rewarding, with income-splitting opportunities), a 33% tax rate, and a structure that’s usable for other business ventures.
Assuming the attribution rules are not an issue, a simplified example of what this might mean is that a contractor trading through a company earns $180,000 profit, and, with a trust structure effective tax liability, enjoys an annual tax liability of approximately $55,000.The same contractor trading as sole trader or company without a trust, though, is going to be looking at a tax liability of around $62,000.That’s a saving of approximately $7000 in tax each year on top of the benefits of asset protection and wealth creation that a trust provides.
Still, it pays to tread carefully. If tax is the primary, or only, motivation for setting up a company with a trust ownership, then the IRD will act and it will cost you a lot more than any tax you intended to save. Which is why, as I say, it’s always crucial to seek out a professional, especially in these interesting economic times.
Stephen Nicholas, whose commentary appears frequently in the media, is a chartered accountant and CEO of Openside, one of New Zealand’s fastest-growing accounting consulting firms. He has held senior positions with Fairfax Media, AMP Financial Services, AXA Funds Management and Citicorp Private Banking, and has a passion (and track record) for making an impact on the performance of businesses.
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