For a shareholder which is best – drawings or salary?
1. What are drawings?
As a shareholder, if you are not paying PAYE on any money that you are taking out of the company, then you are essentially taking drawings out of the company. A company is a legal entity so any funds that it generates is not your money, even if you are the only shareholder in it.
Likewise if you are putting money from your personal bank into the company then it is your funds introduced into the company.
Read More: Tax Season Tips for Small Business Owners
2. Are drawings a tax deductible expense for the business?
Simple answer is No, drawings are not a tax deductible expense of the business. So you will never see drawings in the Statement of Financial Performance/ Profit & Loss Account of the business.
Drawings are posted in the Shareholder Current Account.
3. Can a shareholder take drawings from a business?
Yes, however you cannot take out funds that is in excess of what you had actually put into the business.
What if you have taken out more than what you had put in?
This will create a situation called shareholder current account overdraft. This means that the company must either pay FBT to the IRD or charge the overdrawn shareholder, interest at the IRD prescribed interest rate. The prescribed interest rate is set by the IRD on a quarterly basis and for the quarter ended 31 December 2014 this was at 6.70%.
The interest becomes taxable revenue of the company and it further exacerbates the shareholder current account balance.
4. How to fix an overdrawn shareholder current account?
There are a few ways to fix an overdrawn current account but we will focus on three common ways.
- Repay the loan from the company.
- Declare a shareholder salary, the company needs to earn a profit to allow a shareholder salary to be paid. The shareholder salary will be taxed in the hands of the shareholder.
- Declare a dividend.
Any one of the above or a combination of them can be used to clear the overdrawn shareholder current account.
Points 2 and 3 above will be limited to any retained earnings or past capital gains and the company must be solvent both before and after a dividend or shareholder salary is declared. A company that has made profits and has paid tax will generally have retained earnings.
Generally the dividend is paid in proportion to the number of shares held.
If a dividend is paid the company is required to attach tax credits to it. These are called imputation credits and are simply the tax the company has already paid on its profits (currently 28%) and are recorded as part of the dividend so that the shareholder does not end up paying tax on income that has already been taxed at the company level.
Say if a company has an overdrawn current account of $1,000. The total gross dividend that will need to be declared to clear this will have to be $1,492.53.
In order for a company to declare dividends, it requires 33% in available tax credits to be attached.
These tax credits would be from imputation credits at 28% (the tax that the company has already paid on its profits) and a top up of 5% called the dividend resident withholding tax (DRWT)
5. What is Dividend RWT?
As the company tax rate is 28%, and the top personal and trust rate is 33%, when a dividend is paid the company must pay 5% dividend resident withholding tax (DRWT) to Inland Revenue on the 20th of the month following payment of the dividend.
6. How is the dividend treated by the shareholder?
The shareholder will have to declare the gross dividend and the attached imputation credits and DRWT in their personal tax returns. Depending on their personal tax rate the individual shareholder may be eligible for a refund from the IRD of the DRWT whilst any excess imputation credits will be converted to losses and will be available to be carried forward and offset against their future personal income.
If the dividend is declared to a Trust shareholder than the trust has a choice of retaining this or passing it onto its beneficiaries.
The advice in this article is general in nature. Your specific circumstance may vary therefore you should seek advice on your situation, talk to our specialist for a discussion.