Tax structures for those who are doing private work in addition to their DHB work

Sole Trader

Many people when they first start out in some small business, trade in their own name. This is called being a sole trader.All income comes to you personally and you also claim any expenses against that income in your own name. Because the business is personal you do not need to get a new IRD number (assuming that you already have one).

Many sole traders continue to operate through their own personal bank account. There are some, however, who have a separate bank account nominated as a trading account and called something like ‘John Smith trading as Ace Panelbeaters’. Keeping a separate account like this can make record-keeping much simpler. Sole trader is one of the most convenient and certainly least expensive ownership structures. Accounting and compliance costs are minimal and there is no cost involved in establishing the vehicle in the first place.

For tax purposes the income from your business (after expenses have been deducted) is added to any other income that you might have, perhaps from paid employment or from investments. If you are unfortunate enough to make losses as a sole trader it may be some compensation that they are deducted directly from any other income you may have, reducing your taxable total income. This perhaps is one of the greatest  advantages sole traders have over companies, for which tax losses can at times be difficult (although usually not impossible) to offset against other income. For example, if your newly established retail business makes a loss you may usually offset that loss against the taxable profit from your property investments or from your salary if you have kept your job. You may also usually carry losses that you make in any one year forward to a future year. Thus losses made in the 1998 tax year may be carried forward to 1999. You cannot, however, roll losses back to a previous year. So, if you make a loss in the 1999 year but made a healthy profit in 1998, you cannot re-assess the tax you paid in 1998 and ask for a refund.

Perhaps the greatest disadvantage of trading as a sole trader is the limited ability to income-split with other members of your family. While a sole trader may employ his spouse to assist him and pay a wage for that work (thus in effect income-splitting) there needs to be justification in terms of work actually done (personal exertion) for the income to be passed to the spouse, and prior approval from the IRD. Such prior approval will only be forthcoming if the IRD is satisfied that the spouse is truly working in the business. In addition, if tax rates are changed so that the personal rate is higher than the company rate sole traders will be significantly disadvantaged. On balance, I think that most people should trade through a company or a trust. Sole traders enjoy no limited liability and are therefore directly responsible for all debts, be they to the Inland Revenue Department for unpaid taxes, or to some other creditor.

Limited Liability Company

There are many reasons to trade though a limited liability company, tax advantage being one. In spite of the changes made by the Companies Act 1993, personal liability protection is still afforded by limited liability companies: shareholders have no liability beyond the funds put in as share capital. In this, companies differ from sole traders and partnerships, where liabilities are personal. With a company, any debts are debts of the company, not its shareholders or directors unless the company has been trading recklessly.

Many business people prefer the separation of business and personal activities, as well as appreciating the more established and more serious corporate image that a company presents.

A limited liability company is a complete separate entity from its shareholders. As such, it requires an IRD number and a GST number (if applicable). It cost around $300 to establish a company, and there will be some additional ongoing compliance costs. For a start, every company must furnish the Ministry of Commerce with an annual return of company details, as well as details of any changes of directors and shareholders. Accounting costs will also generally be higher because of the need for compliance with the various acts regulating companies. But because it is a complete separate legal entity, a company can offer some benefits in its ability to minimise tax.

The income of a company is taxed separately from the income of its shareholders. However, the shareholders who are working in the company, or are directors of the company, are often paid a salary once the profit of the company has been calculated. Even though the salary is calculated after the end of the company’s income tax year it is allowed as a deduction in that tax year. The shareholders will pay tax on that income at rates lower than the company would.

If New Zealand ever returns to having a higher personal rate of tax than the company tax (as has been proposed by some political parties) this will obviously have implications in the division of profits between shareholders and the company. Paying the salary at the end of the year also prevents you drawing a salary that may turn out to be greater than the company’s profit for the year. Thus you have the flexibility of deciding how much profit will be taken out personally by the shareholders and how much will be left to be taxed in the company.

Tax in New Zealand – Martin Hawes 1996

Portfolio Investment Entities

The introduction of the PIE regime was a response to the over-taxation of managed funds, which was a major barrier for investors, when considering the whole range of investment options. In the past, funds would pay tax at the company rate (it was then 33 cents in the dollar) and those on a lower rate (say 19.5 per cent) could not claim back the difference. In effect, investors were taxed 33 per cent regardless of what other income they had.

So, the PIE regime was born – and a good thing for investors too. The playing field was tilted away from managed-funds investors but now it has been levelled (in fact, tilted in favour of managed funds in many cases).

Managed funds may now apply to become PIEs (nearly all have) and when they have been registered as PIEs they will deduct tax from each investor’s returns and distribute the income with no more tax for the investor to pay. However, the investor has to tell the managed fund what his or her tax rate is for PIE purposes. This is called the Prescribed Investor Rate (PIR) and it is different from your ordinary tax rate. PIRs are calculated by adding together the ordinary taxable income that some has (e.g. from wages, salary, NZ Super etc.) to the income that they  derive from PIEs. This table shows you what your PIR will be at various income levels.

Note from the table that you cannot pay more than 28 per cent tax if you invest in a managed fund which is PIE. This is especially useful for high-income earners who are on the top rate of tax (33 per cent). If these same people made investments in something that was not a PIE (e.g. if they were direct investors in shares, bonds, bank deposits or property syndicates) their investment income would be added to the income they earn from their salaries and this would be taxed at 33 per cen. By investing in a managed fund is a PIE, their investment is taxed at no more than 28 per cent.

No investment should ever be made solely for tax purposes. However, once a particular type of investment is chosen, you should certainly look for the most tax-efficient means of making the investment and PIEs often fit that bill. For example, if you decide to invest in commercial property; you could choose to invest in a small property syndicate in which case income from the syndicate would be taxed at your own rate. However, if you decide to invest via a managed fund that was a PIE(e.g. Kiwi Income Property Trust o MAP NZ Office Trust) you could be taxed at your PIR which could be lower.

One area where this can be important is for those making term deposits and holding cash with their banks. Banks have established ‘cash PIEs’ – managed funds that invest in term deposits and the like and these have been able to get PIE status. These ‘cash PIEs’ are more tax efficient than ordinary term deposits and savings accounts with much the same risk – except that some of these PIEs may not carry the government guarantee. You should check before investing.