Some time ago I dealt with a case typical of poor business tax planning. I’ve changed the figures and details to preserve confidentiality, but the income tax issue I highlight is real – and common.
My clients, a middle aged couple, bought a small but profitable business in a provincial town. They paid valuation for the plant and stock, an additional $100,000 for goodwill, and traded as a new company. They worked long hours, took personal salaries of $70,000 each annually. They still had profits over, which were left as company profit, paying 28 cents in the dollar in income tax.
After five years, the couple sold the business. The company’s balance sheet just before the sale showed:
| Accumulated earnings: | |
| (company profits over five years, tax paid) |
240,000 |
| Funds due to shareholders | |
| (from undrawn salaries) |
100,000 |
On the sale of the business, the couple got fair value for the plant and stock and an additional sum of $280,000 for goodwill. After the sale there was limited communication with their accountant but no effort to tidy things up and work out the income tax position. With no debt, and the company “cashed up”, they travelled around New Zealand, and eventually bought a business in another part of the country.
The new business was not immediately profitable, and required a considerable input of funds to put things right. These funds were taken from the “cashed up” company. The couple then asked me to take over their accounting work. I did the delayed work for the old company, and the results showed:
| Profits from the final 3 months trading |
108,000 |
| Less shareholder-salaries |
96,000 |
| Company profit |
12,000 |
The couple had withdrawn funds for their general personal needs, their extended travel, and the new business (original price plus extra costs). They had also paid provisional tax for the year of change on the usual formula (previous year plus 5%). All these expenses were “personal” as far as the company was concerned. They totalled $390,000 and were charged to their personal account.
So the shareholders’ account for the full year looked like this:
| Shareholders’ account at start of year |
100,000 |
| Add shareholder salaries |
96,000 |
| Funds available |
196,000 |
| Less personal drawings |
390,000 |
| Shareholders’ account at year end (overdrawn) |
(200,000) |
This situation presents problems for an accountant, as an overdrawn account is potentially taxable as a dividend. That is, Inland Revenue will say “you have overdrawn your account with the company, we are going to call it a dividend and make you pay tax on it”. This could mean as much as $66,000 additional income tax (depending on the couple’s other income).
It had not occurred to my couple that the cash which was in the old company’s bank account was not freely available to them. Their previous accountant had not thought to warn them. Even worse, the overdrawing in some circumstances might have led to fringe benefit tax.
On the figures above, the amount available to the shareholders was only $196,000. The company had paid all its income tax in full, and the $180,000 profit made on the sale of the goodwill was tax-free to the company. Even so, the company must take further steps before the funds are available to the shareholders to draw on.
So what are the options?
Inland Revenue has the right to call overdrawn accounts “dividends” and make them taxable, or perhaps make the overdrawing liable for a fringe benefit tax. However, the situation is manageable, at least in the short term.
As a first step, I re-classified a proportion of the drawings as a loan to the new business, which had been set up under a second company. The loan is set up to carry interest at a commercial rate to avoid the risk of fringe benefit tax. This reduced the overdrawn account from $200,000 to $40,000.
The second step was to begin a process of paying dividends to the couple. These were paid out of the company’s accumulated earnings and credited to the shareholders –all book entries with no cash changing hands. Because the company had paid tax during its first five years, it had built up a significant sum as Imputation Credits. These are sums which could be “attached” to dividends to give the shareholders a tax credit. So that although the dividends are taxable, they come with tax credits, so that the tax impact on their personal returns is minimal.
So the dividend process is the way to manage this situation and prevent the undesirable income tax consequences of over-drawing. Note that the dividend could be a book entry, with no cash transaction needed, but the process must be properly documented with the advice to Inland Revenue. Some withholding tax is also needed, although this is often refundable in the individual’s income tax return. Careful timing of the dividend can alleviate the cash flow effect of the withholding tax.
Lessons to be learned from this experience:
- There may be tax consequences on a sale of your business.
- Seek advice early.
December 2017