This may sound like a silly question, but for income tax purposes there are two types of company, and the main difference is in the way the profits (or losses) are dealt with.
Regular company (my description). Unless you elect otherwise, this is what you are. Profits, if any, are taxed at the company rate of 28%, but there is an opportunity to allocate end-of-year “Shareholder Salaries” to one or more shareholders. The shareholders don’t have to be treated the same.
The shareholder salaries become an expense of the company, and so reduce (and often eliminate) the company profit. The shareholder salaries get taxed in the shareholders’ personal returns at their marginal income tax rate.
There’s a need to allocate shareholder salaries so that you don’t offend the Alienation of Income rule. In short, this rule can stop you allocating an “excess” salary to a shareholder who hasn’t made an equivalent contribution to the company’s business. But this is usually easily managed.
It’s common to allocate salaries so that the relatively low individual tax rates applying to individuals (10.5%, 17.5%, and sometimes 30%) are fully utilised, and then leaving what remains as company profit where the tax rate is 28%.
If this is repeated year after year there are long-term problems with this approach. The retained earnings (that is, company profit less company tax) never really belong to the shareholders without the payment of more tax. In the case of companies with an expanding business, requiring additional capital outlays, these problems get deferred, but they catch up at the end of the life-cycle of a company (for example, on the sale or close-down of a business). In other cases where the shareholders want to treat the retained earnings as their own, shareholders can overdraw their strict tax-paid entitlement (leading to overdrawn current accounts) and capital management problems arise.
An imputation credit system applies to the pay-out of company profits and this limits the “extra” tax to 5% (the difference between the company rate of 28% and the maximum individual rate of 33%).
If the company suffers a business loss, it gets carried forward and is available to be offset against future profits. Note: no immediate benefit.
Look Though Company. You could elect (it’s the shareholders’ decision) to become a Look Through Company (LTC) for tax purposes.
In an LTC, the profits (or losses) are automatically allocated (that is, “looked through”) to the shareholders in the proportions in which they hold the shares. No deviation is allowed.
If there are first year losses (as there often are) those losses are included in the shareholders’ personal tax returns, and will reduce their taxable incomes.
For example, if a shareholder has a marginal tax rate is 33%, he/she will get a $333 income tax credit for every $1,000 loss. A shareholder with a lower marginal rate gets a correspondingly lower tax credit. In appropriate cases, these tax credits get paid out as tax refunds.
LTCs are great when the company is making losses, but before you get too enthusiastic, you need to consider the position if the company makes a profit. Profits get taxed at each shareholder’s marginal rate. If that rate is 33%, that is higher than the standard company rate.
For all purposes other than income tax, an LTC is treated exactly the same as any other company.
You have good time to make up your mind about becoming an LTC. You decide by giving notice only when you file your first income tax return. Your decision becomes retrospective.
It’s possible to change from being an LTC to become a regular company again, but this requires notice in advance. That means a little foresight.
Call Michael on 09-401-6261 to discuss.