Sole trader tax in NZ

No one gets into business because they want to deal with tax – unless they’re an accountant or tax adviser! But tax is inevitable, especially income tax.

While there are other types of business taxes you may encounter – GST, ACC levies, and PAYE deductions for example – income tax is the biggie. And even if you get someone else to handle the income tax for your business, having a basic understanding of how it works for a sole trader is important.

So that’s what we’re going to focus on. Buckle up.

Sole trader income tax

Sole traders are taxed as individuals and the sole trader tax rate is exactly the same as if you were employed by someone else. This makes sole trader income tax somewhat easier to manage than if your business structure is a company.

As a self-employed sole trader, you pay tax on your net profit. This is calculated by filing an annual individual income return (IR3) using your individual IRD number. You declare how much you’ve earned, and the sources of that income. You also declare your business expenses. You may be able to claim back expenses for some of your business activities, for example, home office or vehicle expenses.

When is your sole trader income tax due?

Most businesses have a financial year that begins 1 April and ends 31 March. Each year, you’ll file your income tax return with Inland Revenue (IR) by 7 July (or by the following 31 March if you have an advisor and extension date).

Any income tax that is due (also called residual income tax or RIT) will need to be paid by 7 February next year (or 7 April if you or your advisor have an extension).

So, for example, at the end of your first financial year, you’ll file your income tax return and learn how much residual income tax you owe. You then have until 7 February (in the following calendar year) to pay that (or 7 April if you or your advisor have an extension).

But in your second year things may change. You may have to start paying your income tax during the year; this is called provisional tax. We’ll explain more below about how it works and when you’ll pay provisional tax.

What is provisional tax?

You’ve probably heard people talk about provisional tax, and not in a good way. But provisional tax is just your income tax paid in advance, by instalments, throughout the financial year. It’s not a separate tax. It’s a way to make life easier by spreading your income tax load across the year, rather than paying it in one big lump sum at year end.

You only have to pay provisional tax if you owe $5000 or more in residual income tax (RIT) after filing your IR3. If you owe less than $5000, you don't have to pay provisional tax in the current year. You'll just pay your RIT in one lump sum by 7 February (or 7 April).

Remember we said things might change in your second year? If your RIT is $5000 or more, you have to pay provisional tax throughout the current financial year and also pay that RIT from your first year. That’s usually why people talk badly about provisional tax – it’s that double whammy! To help ease your tax burden in your second year, you can choose to make voluntary payments of tax during your first year of business, or at least put that money aside for the end of the second year.

In your third and subsequent years of business, life should get a bit easier as you should just be paying provisional tax throughout the year (if your RIT was $5000 or more). And if you’re paying the right amounts, there should be no end of financial year surprises.

You still need to file an IR3 by 7 July (or by any extension date) each year, even if you are paying provisional tax. If it turns out you paid either too much or too little provisional tax throughout the year, you’ll get a tax refund, or be asked to pay more tax.

There are some circumstances where IR might charge you interest if you paid less provisional tax than was due. But if you paid more than you needed to, IR may pay you interest on the difference. This is called use-of-money-interest (UOMI).

And if you’re late filing or paying you may be hit with penalties. Let IR know if you think you’re going to be late to see if arrangements can be made.

How is provisional tax calculated?

Unless your business is fortune-telling, you probably don’t own a crystal ball to tell you how much your net profit is going to be. So the amount of provisional tax will generally be based on the previous year’s tax owed.

There are four ways provisional tax payments can be calculated:

• Standard option
• Estimate option
• Ratio option
• Accounting Income Method (AIM)

Check with an accountant or tax advisor as to which option is best for your business. And this may change over time.

Standard option

The standard option is the default option if you don’t choose another one. It’s a good option to use if your profit is likely to remain about the same or increase in the coming year.

The standard option takes your last financial year’s residual income tax and adds 5%. Or 10% if you haven’t filed last year’s return or made a payment, so make sure you get that done!

So if you owed $10,000 for the last year, your provisional tax for the current year will be $10,500 with that five per cent increase applied.

Estimate option

With the estimate option, you tell IR how much income tax you expect to pay. You can adjust your estimates as many times as you like right up until the final instalment is due, and adjust the payments accordingly.

The estimation option is recommended if you know, or expect, your income will decrease over the coming year. For instance, you might be taking time off to have a child or you know you won’t have work from a particular client. It can help you avoid over- or under-paying.

So if your tax was $10,000 last year, but you think it’ll only be $7000 in the current year, you divide your estimate by the required number of payments. If your estimate changes during the year, you adjust the payment amount.

You do need to watch your profit and make sure to adjust your estimates if you use this method. If you get it wrong you could end up with penalties or being charged interest once you’ve filed your return if you haven’t paid enough provisional tax.

Ratio option

The ratio option allows your provisional tax to be calculated based on the income you declare in your GST returns. If your income tends to fluctuate a lot, or is seasonal, the ratio option may be best for you. But there are qualifying criteria. And if you qualify for this method you must let IR know that you want to use it before the start of your financial year.

Accounting Income Method (AIM)

The AIM method uses accounting software, like Xero, to calculate your provisional tax payments so that you only pay tax when you make a profit. If you don’t make a profit you don’t pay any tax that month.

You can use AIM if your yearly turnover is under $5 million. It’s a good method to choose if your business income is irregular or seasonal, if your business is new or growing, or if you can’t give an accurate forecast of the income.

Unlike the other methods, if you use AIM you’ll have to pay provisional tax in your first year of business. But you also won’t end up with the ugly situation in year two of paying last year’s tax as well.

As it’s handled by your advisor, through accounting software, AIM makes provisional tax easier to administer, matches payments with your cash flow, and removes the threats of interest and penalties if you get it wrong. Any overpayments can be refunded straight away instead of waiting until the end of the financial year.

You can compare AIM with the other accounting methods on the IR website.

When is provisional tax due?

Registered for GST: If you’re registered for GST, payment dates* are usually based on the frequency of filing your GST returns. You can learn more about GST in our guide.

• Standard and estimate options: Three instalments by 28 August, 15 January and 7 May. Or, if you file six-monthly, by 28 October and 7 May.
• Ratio option: Six instalments by 28 June, 28 August, 28 October, 15 January, 28 February, and 7 May.
• AIM: Monthly instalments if you file your GST monthly, or every two months if you file your GST two or six monthly.

Not registered for GST: If you’re not GST registered, you’ll make three instalments under the standard and estimate options ( 28 August, 15 January and 7 May) and six two-monthly instalments under AIM.

*When a tax payment due date falls on a weekend or public holiday, it’s shifted to the next working day.

Managing sole trader tax

Keeping on top of your tax obligations is important. Mistakes can be costly in the form of penalties and interest. And poor tax management can affect your cash flow.

There are a number of things you can do to make handling your business tax easier. These include using accounting software like Xero, keeping accurate records of your expenses and income, and getting a bookkeeper, accountant and/or tax advisor to help you.