The Hidden Tax Bill Sitting Inside Your Company

Most business owners look at their company's bank balance and see their own money. It isn't, not yet. There is a second layer of tax sitting quietly on top of that balance, and for a lot of owners that layer just became more expensive.

Companies in New Zealand pay tax at a flat 28 percent. That feels like a good outcome, and in one sense it is. But 28 percent is not the final tax bill. It is a deposit. The profit still belongs to the company, and the company is a separate legal entity from the people who own it. To get that profit into shareholders' hands, it has to come out as a dividend, and a dividend carries its own tax cost.

A dividend attracts an extra 5 percent withholding tax, then is taxed again at the shareholder's marginal rate. With the trust tax rate now sitting at 39 percent, that top rate touches far more people than it used to. Anyone earning over $180,000 a year, including plenty of business owners who already draw a full salary, will pay 39 percent on every extra dollar of profit that comes out. If a shareholder has already used up their lower tax brackets through salary, the whole dividend lands at the top rate.

The retained earnings surprise

This is where clients are often caught out. The company's retained earnings can grow into a substantial number, and it can feel like a win, right up until someone needs to draw on it. That is when the tax bill shows up, often bigger than expected, because nobody had planned for the gap between what the company earned and what the shareholder can actually keep.

Two ways to handle it

There isn't one right answer here. It depends on what the shareholders actually need the money for, and how comfortable they are carrying a known future tax liability. In practice, we see two strategies.

1.      Retain profits in the company. This suits a business that's growing, investing, or repaying debt, where cash is genuinely needed inside the business rather than in shareholders' pockets. The trade-off is that the tax isn't avoided, only deferred, and that deferred liability needs to be tracked and planned for rather than forgotten.

2.      Run a regular, consistent dividend policy. This means paying tax at 39 percent most years rather than letting a large balance build up. It's a more conservative approach. Profits are distributed as they're earned, cashflow is smoother, and there's no lumpy one-off event that then triggers a delayed and painful provisional tax bill.

How this worked in a client's favour

We recently worked with a client who sold their business with substantial retained earnings still sitting in the company. Because they were already on a high income from other work, it never made sense to draw those profits out earlier. The retained earnings had instead been used to pay down business debt.

The timing turned out to work in their favour on two fronts. First, the sale proceeds gave them the cash to cover the extra withholding tax and the top-up to 39 percent when the dividends were eventually paid. Second, because the business had been sold, they no longer had a salary from it in that financial year. The dividends were taxed at their lower marginal rates instead of the 39 percent they would have paid while still drawing income. It was still a real upfront cost, and the outcome depended heavily on timing, but it shows why this is worth planning rather than leaving to chance.

The bigger picture

Retained earnings sitting in a company aren't free money waiting in the bank. Sooner or later, tax catches up with them. The question isn't whether to think about it, it's whether you decide the timing deliberately or let it happen to you.

If you're not sure which approach fits your business, that's worth a conversation before the balance keeps growing.