Many businesses operate through a limited liability company structure. Each year, the profit the company has made for the year is either distributed to shareholders as a salary or kept in the company to be used for debt repayment or growth and this ends up in retained earnings. Often a mixed approach is applied.
If all profit has been distributed to shareholders as a salary each year, then there will be no retained earnings, and no dividends will be required to be paid out to the shareholders in future, and you can stop reading.
However, profit left in the company becomes retained earnings and will eventually have to be paid out to the shareholders as dividends, often when the company ceases, before any major shareholding changes take place, when a shareholder needs funds for personal asset purchases and to mitigate increasing tax rates.
When a company pays out a dividend to their shareholders, they attach the tax the company has paid on this profit, known as “imputation credits”. As the company tax rate is 28%, these imputation credits attach to the retained earnings at 28%.
However, a company must increase these tax credits attached to dividends by 5% to a total of 33%, or 11% for a total tax credit on the dividend of 39% at the time of passing a dividend to shareholders. This additional tax of 5% or 11% is called dividend withholding tax and is paid to IRD on the 20th of the month following the dividend being “declared” by the directors of the company.
We recommend 39% if the shareholders annual income is likely to go above $180,000 including the gross dividend.
If you have retained earnings in your company, be aware it represents a deferred tax liability which you may not be aware of. You can find retained earnings in the equity section at the bottom of your balance sheet.
Careful planning in the timing of dividend payments and having a dividend strategy which can be implemented year on year can result in significant tax savings.
