Kellett Accounting Solutions Limited
Tax specialists for network marketing and home based business professionals
What kind of entity should you be trading as?
You can choose to operate your business in a number of different structures which will have varying tax and legal implications.
The first thing to note is that if you want to trade under a name that isn't your own (as long as it's not offensive or owned by someone else), you can do that under any structure. You can register a company with the Companies Office under any name (as long as the name isn't already reserved), apply for a GST number for a partnership under your choice of names or, if you're trading on your own, you can do that by simply "trading as" your chosen name.
Any entity can (or may be required to) be registered for GST and if you're operating a business you will also be required to file income tax return(s).
So, how do you choose what the best entity is for you to operate as?
If you're running your business on your own, your main choices are as a sole trader or a company (although you might like to consider including your spouse/life partner in your business if that's reasonable and beneficial, in which case you might also be able to consider a partnership.)
If there are two or more people who own the business (so employees don't count for this purpose), you'll need to choose between a partnership or a company. (While it is also possible to trade through a trust, this is quite complicated and likely to not be appropriate for the kind of self employed clients I usually deal with).
To further complicate things, there are two main types of companies: a private company and a look through company (LTC).
Sole Traders
A sole trader is the easiest way to set yourself up in business. You'll use your existing IRD number (which you may need to register for GST). You'll need to file an IR3 personal income tax return on which your business profits (or losses) will be combined with all your personal income. Your income tax will be calculated based on this total taxable income figure, any tax you've paid will be deducted, and you'll end up with either a tax bill (due on 7 April 2014 for taxes for the year ended 31 March 2013) or a refund (which will be paid out as soon as your return has been filed and processed.
Apart from being the simplest (and cheapest) way to start up a business, the advantage of operating as a sole trader is that if you make losses as you start up, as long as you've paid some tax (through PAYE on wages, or RWT on interest, etc) you'll receive a tax refund.
Another nice thing about operating as a sole trader is that, in most circumstances, as long as you pay the taxes the IRD is expecting and when they're expecting them, you won't be charged use of money interest when you start having to pay provisional tax (which is when your tax bill is more than $2,500 per annum), even if you haven't paid provisional tax in the first year. (However, I would suggest that you do start to put aside money to cover these taxes as soon as you start to cover your expenses; why and how to calculate provisional tax will be the subject of a future article).
Often when someone starts a business, they're doing the work but their spouse is providing the funds from a full-time job. If this is the case, operating as a sole trader is fine; if no tax has been paid through PAYE or RWT, any losses will just accumulate until the business is profitable, and then the profits will be offset against the losses until the losses are used up, and only then will there be any tax to pay. Another option in these circumstances is to operate the business as a partnership, with one partner being the active partner and the other effectively being an investor. As a result, the investor partner's share of any losses should result in a tax refund.
Partnerships
A partnership is the easiest way for two or more people to operate a business together.
For partners who aren't spouses, it's probably best to contribute the same amount of money into the business, and then to share equally in the profits or losses.
For anything other than an equal split of the profits, you'll need to have a partnership agreement that all partners sign so that there's absolute certainty as to everyone's rights and obligations.
With spouse/partners (only for businesses that aren't going to be registered for GST), it's possible to create financial statements for the partnership, but just to split the profits 50/50 in the two spouses' personal tax returns.
For other situations, you'll need to apply for a non-individual IRD number using an IR596, possibly register for GST under that number, and the tax return to use is an IR7, which will calculate a profit or loss for the partnership, which is then split between the partners and carried into their personal tax returns, so the impact will depend on each partner's level of income as to how much tax they'll pay. (Where one partner earns more than one or more of the other partners, they'll receive more of a tax refund while the business makes losses (particularly if the loss causes their income to move down a tax bracket) BUT once the business becomes profitable, the tax to pay will also be higher.
There are two main disadvantages of partnerships. One is that there's no legal separation between the business and the partners (except in limited partnerships, which are a legal entity, so you'd need a lawyer to draw up the agreement, and they're much more complicated), so if someone sues the business, they can try to recover from all or any of the partners (i.e. if one of the partners has more assets than the others, they could be sued alone).
The other disadvantage is that if one of the partners wants to leave the partnership, that ends the partnership and you need to form a new partnership with either the remaining partners or a new group.
Companies
A company legally separates the business from the individual shareholders. This means that (unlike the partnership, as mentioned above), the shareholders of a company can only be sued up to the level of their investment in the company), unless the shareholder is also a director and they fail in their directors' duties (which basically means acting legally and responsibly) or allow the company to continue to operate while it doesn't have enough money to pay its debts.
It's the most expensive option, costing $10.22 to reserve the company name, $150 to incorporate it, and you'll pay an annual fee of $45 to the Companies Office. (All these things are done at the Companies Office website (www.business.govt.nz). One convenient thing is that when incorporating the company, you can also apply for the company's IRD number and register it for GST at the same time.
In addition to the ongoing costs of company registration with the Companies Office, there are additional legal requirements for companies such as keeping minutes and statutory records.
An advantage of a company is that you can change owners by selling shares (there are some limitations on this in the case of look through companies, see below), and you can have different shareholders holding different numbers of shares and therefore having more say in the operation of the business, and receiving a higher share of the profit or loss.
A standard company can distribute its profits via salaries to the shareholders (which can be through the PAYE system or an annual adjustment as part of the income tax return) or through a dividend (which will have imputation credits attached to it, earned when the company paid tax through a previous tax return. These imputation credits are treated effectively as tax paid in the individual's tax return). Any remaining profit is taxed at the flat company tax rate (28% in 2013... individual tax rates range from 10.5% to 33%). Any losses stay within the company to be offset against future profits. (The company tax return is an IR4.)
Look Through Companies
A look through company (LTC) retains the legal separation of a company but for income tax purposes the IRD treats the company as if it was a partnership (in fact, LTCs file IR7 tax returns the same way as partnerships do), which means that the company's profits (and losses) are passed through to the shareholders based on the percentage of the company's shares that they hold.
There are three requirements for a LTC:
The final thing to know about LTCs is that if you want to pay one shareholder a salary from the company (e.g. to acknowledge the work they have done in the business, particularly if other shareholders are less hands on), this must be done through the PAYE system. The salary then becomes an expense which is included in the calculation of the profit (or loss) which is then distributed to all shareholders (including the one who's received the salary).
If, having read all this, you want to discuss your individual situation, please contact me.
The first thing to note is that if you want to trade under a name that isn't your own (as long as it's not offensive or owned by someone else), you can do that under any structure. You can register a company with the Companies Office under any name (as long as the name isn't already reserved), apply for a GST number for a partnership under your choice of names or, if you're trading on your own, you can do that by simply "trading as" your chosen name.
Any entity can (or may be required to) be registered for GST and if you're operating a business you will also be required to file income tax return(s).
So, how do you choose what the best entity is for you to operate as?
If you're running your business on your own, your main choices are as a sole trader or a company (although you might like to consider including your spouse/life partner in your business if that's reasonable and beneficial, in which case you might also be able to consider a partnership.)
If there are two or more people who own the business (so employees don't count for this purpose), you'll need to choose between a partnership or a company. (While it is also possible to trade through a trust, this is quite complicated and likely to not be appropriate for the kind of self employed clients I usually deal with).
To further complicate things, there are two main types of companies: a private company and a look through company (LTC).
Sole Traders
A sole trader is the easiest way to set yourself up in business. You'll use your existing IRD number (which you may need to register for GST). You'll need to file an IR3 personal income tax return on which your business profits (or losses) will be combined with all your personal income. Your income tax will be calculated based on this total taxable income figure, any tax you've paid will be deducted, and you'll end up with either a tax bill (due on 7 April 2014 for taxes for the year ended 31 March 2013) or a refund (which will be paid out as soon as your return has been filed and processed.
Apart from being the simplest (and cheapest) way to start up a business, the advantage of operating as a sole trader is that if you make losses as you start up, as long as you've paid some tax (through PAYE on wages, or RWT on interest, etc) you'll receive a tax refund.
Another nice thing about operating as a sole trader is that, in most circumstances, as long as you pay the taxes the IRD is expecting and when they're expecting them, you won't be charged use of money interest when you start having to pay provisional tax (which is when your tax bill is more than $2,500 per annum), even if you haven't paid provisional tax in the first year. (However, I would suggest that you do start to put aside money to cover these taxes as soon as you start to cover your expenses; why and how to calculate provisional tax will be the subject of a future article).
Often when someone starts a business, they're doing the work but their spouse is providing the funds from a full-time job. If this is the case, operating as a sole trader is fine; if no tax has been paid through PAYE or RWT, any losses will just accumulate until the business is profitable, and then the profits will be offset against the losses until the losses are used up, and only then will there be any tax to pay. Another option in these circumstances is to operate the business as a partnership, with one partner being the active partner and the other effectively being an investor. As a result, the investor partner's share of any losses should result in a tax refund.
Partnerships
A partnership is the easiest way for two or more people to operate a business together.
For partners who aren't spouses, it's probably best to contribute the same amount of money into the business, and then to share equally in the profits or losses.
For anything other than an equal split of the profits, you'll need to have a partnership agreement that all partners sign so that there's absolute certainty as to everyone's rights and obligations.
With spouse/partners (only for businesses that aren't going to be registered for GST), it's possible to create financial statements for the partnership, but just to split the profits 50/50 in the two spouses' personal tax returns.
For other situations, you'll need to apply for a non-individual IRD number using an IR596, possibly register for GST under that number, and the tax return to use is an IR7, which will calculate a profit or loss for the partnership, which is then split between the partners and carried into their personal tax returns, so the impact will depend on each partner's level of income as to how much tax they'll pay. (Where one partner earns more than one or more of the other partners, they'll receive more of a tax refund while the business makes losses (particularly if the loss causes their income to move down a tax bracket) BUT once the business becomes profitable, the tax to pay will also be higher.
There are two main disadvantages of partnerships. One is that there's no legal separation between the business and the partners (except in limited partnerships, which are a legal entity, so you'd need a lawyer to draw up the agreement, and they're much more complicated), so if someone sues the business, they can try to recover from all or any of the partners (i.e. if one of the partners has more assets than the others, they could be sued alone).
The other disadvantage is that if one of the partners wants to leave the partnership, that ends the partnership and you need to form a new partnership with either the remaining partners or a new group.
Companies
A company legally separates the business from the individual shareholders. This means that (unlike the partnership, as mentioned above), the shareholders of a company can only be sued up to the level of their investment in the company), unless the shareholder is also a director and they fail in their directors' duties (which basically means acting legally and responsibly) or allow the company to continue to operate while it doesn't have enough money to pay its debts.
It's the most expensive option, costing $10.22 to reserve the company name, $150 to incorporate it, and you'll pay an annual fee of $45 to the Companies Office. (All these things are done at the Companies Office website (www.business.govt.nz). One convenient thing is that when incorporating the company, you can also apply for the company's IRD number and register it for GST at the same time.
In addition to the ongoing costs of company registration with the Companies Office, there are additional legal requirements for companies such as keeping minutes and statutory records.
An advantage of a company is that you can change owners by selling shares (there are some limitations on this in the case of look through companies, see below), and you can have different shareholders holding different numbers of shares and therefore having more say in the operation of the business, and receiving a higher share of the profit or loss.
A standard company can distribute its profits via salaries to the shareholders (which can be through the PAYE system or an annual adjustment as part of the income tax return) or through a dividend (which will have imputation credits attached to it, earned when the company paid tax through a previous tax return. These imputation credits are treated effectively as tax paid in the individual's tax return). Any remaining profit is taxed at the flat company tax rate (28% in 2013... individual tax rates range from 10.5% to 33%). Any losses stay within the company to be offset against future profits. (The company tax return is an IR4.)
Look Through Companies
A look through company (LTC) retains the legal separation of a company but for income tax purposes the IRD treats the company as if it was a partnership (in fact, LTCs file IR7 tax returns the same way as partnerships do), which means that the company's profits (and losses) are passed through to the shareholders based on the percentage of the company's shares that they hold.
There are three requirements for a LTC:
- the company (not necessarily the shareholders) must be resident in New Zealand.
- all the shares must be owned by individuals, trustees or another LTC
- there must be no more than five shareholders (in some cases, related or married shareholders may count as one for the purposes of this count; please contact me for more details if this is may be relevant to you).
The final thing to know about LTCs is that if you want to pay one shareholder a salary from the company (e.g. to acknowledge the work they have done in the business, particularly if other shareholders are less hands on), this must be done through the PAYE system. The salary then becomes an expense which is included in the calculation of the profit (or loss) which is then distributed to all shareholders (including the one who's received the salary).
If, having read all this, you want to discuss your individual situation, please contact me.