Drawings & Shareholders Salaries, how do they work?
This blog will give you a good understanding of the differences.
Drawings from a company is a term used to define withdrawals of cash from a company by a shareholder. A common misconception is that a shareholder is taxed on these drawings, but as you will see this is not entirely correct, we explain how the two are intertwined.
Firstly, there are a few principles to understand -
- Tax is levied on profits. Profits = Sales – costs
- Tax is calculated on an invoice (accruals) basis
1. Tax is levied on Profits.
Ok, so tax is levied on profits, lets look at a simple example of what profits are
In this scenario, income tax is calculated on the profit of $7,000. Seems pretty straightforward, and in this simplest of scenarios the corresponding result would be that there is $7,000 now sitting in the bank account.
Unfortunately, the profit calculation is not this straightforward. The income Tax Act is a few thousand pages long and explain the principles of what is and isn’t a sale or a cost. For most small-medium business owners it will be costs that trip up your understanding.
|Materials||Withdrawals of cash (drawings)|
|Depreciation||Purchase of assets greater than $500|
|Interest||Principal repayments of loans|
|Stock that is sold||Payment of taxes (income tax, GST etc)|
As you can see from the table above there are a few major things that aren’t considered costs. You can see that purchasing a piece of equipment at $1,000 won’t reduce your profit, because it is an asset, but creates a depreciation expense which is a calculation that becomes a cost. You get to claim this over a number of years depending on the type of asset purchased.
2. Tax is calculated on an invoice (accruals) basis
Income tax is calculated on an invoice (accruals) basis. This is even though for GST purposes you could be registered on a payments or invoice basis. The two taxes operate independently of each other.
What this means is that at the end of a tax period, the calculation of sales, costs, and profit is calculated not only on what cash transactions have been completed but also on what has been invoiced out to your customers or from your suppliers
Let's update our scenario for a few extra variables
- Depreciation on the $1,000 asset is 10%
- There is $2,000 of invoices owed from customers at the end of the period
- There is $750 owing to suppliers at the end of the period.
- The owner withdraws the cash available in the bank as drawings
Profit & Loss Statement
|Drawings by owner||-$6,000|
In this particular tax period, profit was $8,150 and the owner withdrew $6,000.
Remembering our first principle, tax is levied on profits, meaning the tax is calculated on profit of $8,150, not the $6,000.
Furthermore, the owner now effectively has taken a loan from the company of $6,000. If not addressed, because this loan is to someone associated with the company, there is additional tax that needs to be paid. This is where the shareholder salary comes in.
A shareholder's salary is a non-cash cost recorded by accountants to allocate profit to a working shareholder of the business. This is done to counterbalance both the profits generated and the drawings by the business owner.
Let's have a look at what things look like once a shareholder's salary is allocated.
Profit & Loss Statement
Shareholders Current Account
A “shareholders' current account” is essentially a ledger between the company and shareholders of what has been recorded as in and out between the two parties. This will include cash-based movements (called capital introduced, or drawings) and non-cash movements (such as shareholders' salaries, recording expenses paid by the shareholder on behalf of the company, etc)
Common Question: Why allocate a salary greater than the drawing? Company tax rate is 28% and my personal top tax rate is 33%
Yes, on the face of it, we could allocate a shareholders' salary equal to the cash drawings of $6,000. This would leave $2,150 in the company. The shareholder would be taxed on their earnings of $6,000 and the company would be taxed on the $2,150. Assuming the shareholder is on the top tax rate there would be a reduction in overall tax paid in that year.
The problem is, is that the company tax rate of 28% is only ever a temporary tax rate, the next year the money from the invoices come in($2,000) and supplier bills are paid ($750) you now have an additional $1,250 in your bank account so you chose to withdraw it.
The accountant can’t record a shareholder's salary as a cost because there are no costs, they were recorded in the profit & loss statement of the prior year, all that has happened is that the money has been collected. Instead, the profits were retained in the company, so to counter balance the shareholders withdrawal of that cash a dividend needs to be declared.
When a dividend is declared an additional 5% of tax is payable, this tops the company tax rate from 28% to 33%.
The kicker is that the declaration of a dividend involves calculations, reconciliations, resolutions, tax forms. This comes at a fee from your accountant. So not only do you end up paying the same amount of tax you also have additional fees from your accountant.
Common Question: When would it be appropriate to pay dividends instead of a salary.
Everyone’s situation is unique and covering all potential scenarios would prove to be difficult a couple of common reason would be
- There are other shareholders involved and there is a set agreement for the amount a working shareholder is to be paid. Profits over and above what should be allocated to all shareholders by way of dividend
- The medium-term focus is to have a set salary and reinvest profits into the business to purchase new assets, take on new staff, repay loans. In this situation the company tax rate provides a cashflow benefit for that medium term.
We hope this blog has been helpful guide in your understanding of how drawings and shareholders salaries work. If you would like more clarification please contact one of the evolve team for further information.