Understanding the Difference Between Shareholder Salary and PAYE Salary

When running a business, particularly as an owner-operator, understanding how you receive remuneration is crucial for both financial planning and tax compliance. Two primary methods exist for compensating business owners: shareholder salary and PAYE salary. While both represent the market value of your work within the business, they operate very differently in terms of tax treatment, cash flow management, and administrative requirements.

What is a Shareholder Salary?

A shareholder salary is essentially a “paper entry”. This occurs at the end of the financial year as part of your annual financial statements preparation. This arrangement is specifically designed for businesses operating under a company structure, where the owners are shareholders of the company.

How Shareholder Salary Works

Throughout the business year, owner-operators typically take drawings from the company bank account to meet their personal expenses. These drawings represent money taken from the business for personal use, but they don’t immediately trigger tax obligations in the same way a traditional salary would.

At year-end, when financial statements are prepared, these drawings are calculated and recorded as a debt that you, as the shareholder, owe to the company. To offset this debt, a shareholder salary is allocated to you based on the market value of the work you’ve performed for the business throughout the year. This salary serves to reduce or eliminate the debt created by your drawings.

The key characteristic of a shareholder salary is that it’s determined retrospectively – after the year has ended and all the financial information is available. This allows for flexibility in determining the exact amount based on the company’s performance and your contribution.

Learn more: Drawings and shareholder current accounts

Tax Implications of Shareholder Salary

One of the most significant aspects of receiving a shareholder salary is how taxes are handled. Instead of paying income tax monthly through the Pay As You Earn (PAYE) system like regular employees, shareholders typically pay their personal income tax through the provisional tax system.

Under the provisional tax system, payments are made three times per year:

• First installment due on August 28
• Second installment due on January 15
• Third installment due on May 7

Any remaining tax obligations are settled through terminal tax, which is due in April following the end of the tax year.

Learn more: Your Guide to Understanding What is Provisional Tax in NZ

Advantages and Challenges of Shareholder Salary

Advantages:

• Cash flow benefits: By deferring tax payments, you have access to more cash throughout the year for business operations or personal expenses
• Flexibility: The salary amount can be adjusted based on business performance and personal circumstances
• Simplicity: Fewer administrative requirements during the year

Challenges:

• Tax management: You must be disciplined about setting aside money for tax payments to avoid penalties and interest charges from Inland Revenue
• Lump sum payments: Large tax bills can be challenging to manage if cash hasn’t been properly reserved
• Uncertainty: You don’t know your exact tax liability until year-end

What is a PAYE Salary?

A PAYE (Pay As You Earn) salary operates much like a traditional employment arrangement, even when you’re the business owner. Under this system, you receive regular salary payments with tax deducted at source, just like any other employee of the company.

How PAYE Salary Works

With a PAYE salary arrangement, you determine your salary amount (based on the market value of your work) and pay yourself regularly – typically weekly, fortnightly, or monthly. The business calculates and deducts income tax, ACC levies, and other applicable deductions from each payment.

You receive a net payment directly into your personal bank account, while the business handles all tax obligations on your behalf by making monthly payments to Inland Revenue. This creates a clear separation between business finances and personal finances.

Tax Implications of PAYE Salary

The primary advantage of PAYE salary from a tax perspective is that your obligations are current throughout the year. Each pay period, the correct amount of tax is calculated and paid, meaning you’re unlikely to face large tax bills or be required to make provisional tax payments.

At year-end, if you’ve only received PAYE salary income, you may be entitled to a tax refund if too much tax has been deducted, or you might owe a small amount if insufficient tax was paid. However, these amounts are typically much smaller than the large provisional tax payments required under the shareholder salary system.

Advantages and Challenges of PAYE Salary

Advantages:

• Current taxation: Tax obligations are met throughout the year, reducing year-end surprises
• Budgeting clarity: Regular net pay makes personal budgeting easier
• Separation of finances: Clear distinction between business and personal expenses
• Reduced compliance: No need to manage provisional tax payments

Challenges:

• Cash flow impact: Higher immediate tax payments can affect business cash flow
• Less flexibility: Salary amounts are typically fixed for periods of time
• Administrative requirements: Monthly PAYE returns and payments must be processed

Learn more: Understanding PAYE: A Guide for New Zealand Employers

Key Differences in Practice

Cash Flow Management

The most significant practical difference between these two approaches lies in cash flow management. Shareholder salary arrangements provide better short-term cash flow for the business since tax payments are deferred. However, this requires excellent financial discipline to ensure tax obligations can be met when due.

PAYE salary arrangements provide better cash flow predictability for personal finances, as you receive regular net payments that you can budget around. However, the business faces higher immediate cash outflows due to tax payments.

Administrative Requirements

Shareholder salary arrangements require less administration during the year but more complex calculations at year-end. The business must maintain accurate records of drawings and ensure proper documentation of the salary allocation.

PAYE salary arrangements require consistent monthly administration, including calculating pay, processing deductions, and making payments to Inland Revenue. However, year-end requirements are typically simpler.

Risk Management

From a risk perspective, shareholder salary arrangements carry the risk of cash flow problems when tax payments are due. This is especially the case if the business hasn’t been profitable enough to set aside sufficient funds.

PAYE salary arrangements carry less tax-related risk since obligations are current. However, they may create cash flow pressure for businesses with seasonal or irregular income patterns.

Making the Right Choice

There’s no universally “right” choice between shareholder salary and PAYE salary – the best option depends on your specific circumstances, including:

• Business cash flow patterns: Seasonal businesses might benefit from the flexibility of shareholder salary
• Personal financial discipline: Those who struggle to save for large payments might prefer PAYE salary
• Business structure: Only company structures can use shareholder salary arrangements
• Growth stage: Established businesses with predictable income might find PAYE salary easier to manage
• Personal preferences: Some people prefer the certainty of regular net pay, while others value the flexibility of deferred tax

Professional Advice is Essential

Given the complexity of tax laws and the significant financial implications of this choice, it’s crucial to seek professional advice from qualified accountants. We can analyze your specific situation, including your business structure, cash flow patterns, and personal circumstances, to recommend the most appropriate approach.

Your advisor can also help you understand the compliance requirements for whichever method you choose and ensure you’re meeting all legal obligations while optimizing your tax position.

Conclusion

Both shareholder salary and PAYE salary arrangements have their place in business remuneration strategies. The choice between them should be based on careful consideration of your business’s cash flow, your personal financial management preferences, and the administrative capabilities of your business.

Remember that this choice isn’t necessarily permanent. For example, can change from one system to another, though this should be done with professional guidance to ensure compliance and optimize timing. Business Like NZ Ltd can help with this!

The most important factor is ensuring that whichever system you choose is properly implemented and managed. Appropriate record-keeping and compliance procedures must be in place. This will help you avoid penalties, optimize your tax position, and maintain good relationships with Inland Revenue while supporting your business’s growth objectives.