KEY POINTS:
Have you heard the story about the mega-bucks barrister who paid less than the cost of an ice cream a week in child support?
This case may be an urban legend. It's amazing, however, how often high earners can restructure their incomes to earn virtually nothing on paper - meaning they pay less tax than some low earners, qualify for the Working for Families tax credits, and can escape responsibilities such as child support.
Many don't even have to change jobs. The conversion of employees to self-employed contractors or changing jobs to become self-employed is something that happens every day of the week, says Peter Sibbald, author of Pay Zero Taxes, although they do need to formally resign.
As a self-employed person or company you can claim business "expenses" such as a proportion of your home office expenses, motoring costs, rates and mortgage interest before tax is deducted on your income. That makes these costs tax free.
For relatively low-paid workers such as agency nurses who need to travel to different locations by car, being self-employed means they can claim their travel costs as a business expense, says Sibbald.
The higher-paid worker is able to pay tax at a lower rate than they would as an employee.
Bill Hale, tax partner at Deloitte, estimates that an independent contractor earning over $60,000 who was able to claim back $15,000 in expenses would be around $5850 better off than an employed colleague on the same gross salary who was incurring the same level of expenses.
If, says Hale, your sole reason for shifting from employed to self- employed is tax, not commercial considerations, then you could suffer the ire of Inland Revenue.
The big downside of carrying on in much the same job, but becoming self-employed, is that you no longer have the guarantees of an employment contract, holidays, sick pay, grievance procedures and employment courts to back you up.
From an employer's point of view, having self-employed contractors or companies invoicing them for services rather than employees can save a lot of hassle, says Sibbald. As a result, self-employed people need to get a higher hourly rate than they did as an employed person to make this worthwhile.
Self-Employment Benefits
The key for many self-employed people is that the expenses they claim are often for goods and services that they would buy anyway, such as petrol and newspapers or magazines. So being able to pay them out of your pre-tax income and reclaim any GST paid can make a lot of sense.
As a self-employed person you can also choose to employ your spouse and/or children and pay them to do work such as invoicing. The advantages of this include being able to reduce your own income and, if they're paying tax at a lower rate, the family gets more money in the hand after tax.
Many self-employed people and company owners are able to structure their income so that they qualify for some of the Working for Families tax credits. It's important, however, to pay yourself at a market rate that does not put you on the IRD's radar for tax avoidance, says Hale.
Company Versus Self-Employed
The advantages of a limited liability company over self-employment are numerous.
With a company, says Hale, it's possible to ensure your salary is no more than $60,000 personally, which you pay tax on at your marginal rate at up to 33 per cent, and the remainder, which would have been taxed at 39 per cent in your pocket, is subject to the 33 per cent company rate if retained by the company. Business surpluses can be kept within the company to be taken as a tax-free capital gain at a later date.
Conversely, says Sibbald, if you are taxed at 19.5 per cent it makes more sense to stream the company's profits to yourself as an individual and pay the lower tax rate.
Another advantage of working through a company or partnership is that you can, as well as paying yourself a salary, contribute up to 4 per cent tax free into a Kiwisaver retirement account, matched by another 4 per cent from your salary.
Sibbald says with all of the benefits of companies, the only real reason to choose a self-employed status over company ownership is that you have less paperwork and fewer formalities to deal with as a self-employed person.
Tax Avoidance
There is a fine line between tax efficiency and tax avoidance. Converts to self-employment need to be very careful of grey areas in the laws which do not define "employment" and "self-employment".
The Inland Revenue's IR336 form poses a series of questions, which you need to answer "yes" to most of, to qualify as self-employed.
They cover issues such as who decides or controls how you do the work, such as setting when you take holidays, where, when and what hours you work.
This doesn't of course mean just because you work at your employer's premises you are an employee, not a self-employed person.
But it means you need to be able to build a case for yourself that errs on the side of the self-employed equation.
Paper Mountain
Going self-employed or starting a business involves a certain amount of paperwork. First of all, you'll need to apply for GST registration and if you plan to run a company, you'll need a non individual tax number. You'll need to fill in six-monthly GST returns as well as an IR3 tax return or company tax return. If you're paying child support, fill out an IR116 form, which can be found on the IRD's website, and estimate your current income.
Running a company has its expenses such as $60 to reserve a company name and register the company via the companies.govt.nz website, annual (tax deductible) accountancy fees of up to $2000 per year, and the need for additional bank accounts.
The shares of your company can be held by your family trust, says Hale. One advantage of this is that dividends are passed up to the trust from the company rather than gifted, and belong to the trust automatically, protecting the dividends for future generations from relationship breakdowns or business creditors.
There are plenty of pitfalls for the unwary. If, for example, you run your own company, but more than 80 per cent of your work is for one employer, you could be caught by the IRD's "attribution rules", which mean that your personal services income after the deduction of your expenses could be returned to you by the IRD and taxed at your own marginal rate. "Getting stuck in these rules can be very ugly," says Hale.
If your income is structured deliberately to avoid child support payments, the IRD can hold an "administrative review".
Company owners also need to be wary of the fringe benefit tax (FBT) rules, says Hale.
If, for example, your business owns a car and that is used by you the employee for personal use, the business could be charged FBT.
