In 1789, Benjamin Franklin stated that “in this world nothing can be said to be certain, except death and taxes.” A leading thinker of his time, it is a shame he didn’t think harder about how we account for those taxes in our data files and financial reports.
The issue of how to account for income tax for our clients is a complicated one. But should it be? We can account for income and expenses, from many different sources for many different clients across many different industries without breaking a sweat. But when it comes to accounting for income tax, something that as Mr Franklin stated was a certainty, there is often confusion.
Why is accounting for income tax such a perplexing issue?
One of the complicating factors in determining how to account for income tax is due to the different structures in which clients operate. The four main trading structures of Sole trader, Partnership, Company and Trust all treat income tax differently.
So how do the structures differ?
SOLE TRADER
A sole trader is the simplest form of business structure; a sole trader is an individual who is legally responsible for all aspects of the business. They own the assets, owe the liabilities and although they may use a trading name different to their legal name, they are the reporting entity.
Unlike other structures below, there is no governing document.
Who pays the tax on profit? – The individual does.
PARTNERSHIP
A partnership is an association of two or more people (or entities) operating a business as partners. The partners may have equal interests in the business or unequal interests. This ownership interest amongst other things is determined by the partnership agreement.
The partnership agreement is the governing document of the partnership.
Who pays the tax on profit? – The Partners do.
The net profit of the partnership is split between the partners based on the details contained in the Partnership agreement. This income is then dealt with in their individual tax returns. Therefore, each individual partner pays their own tax.
COMPANY
For these purposes, let’s consider a Company as being a small Private Company with two Directors and 2 shareholders. Each have equal ownership interest within the company.
A company is a legal entity and it is governed by the Corporations Act 2001. As it is a legal entity, it is separate from its own directors and shareholders. Companies are regulated by ASIC (Australian Securities & Investments Commission).
Each company may have its own set of rules which can be laid out in its constitution.
Who pays the tax on profit? – The Company does.
TRUST
For these purposes, let’s consider a Trust as being a typical Family Trust (Discretionary Trust) that has a Company as its Trustee.
Trusts are, in principle, a very simple concept. A trust is a private legal arrangement where the Trustee holds assets (for example property or cash) in trust for the benefit of the beneficiaries.
For example:
Jackson and Tara are the Trustees of the Charming Family Trust. They hold a rental property in Stockton as well as a share portfolio in trust for the beneficiaries, their children Abel and Thomas.
The trust deed contains the rules within which the trust must operate, it dictates its investment guidelines and describes how benefits will accrue to the beneficiaries under the trust.
Who pays the tax on profit? – The beneficiaries do.
This income is then dealt with in their individual tax returns. Therefore, each individual beneficiary (Abel and Thomas) pays their own tax.
ACCOUNTING FOR INCOME TAX
What do we do with the data file?
Well, for Partnerships and Trusts, it is easy. We don’t have to worry about this. A Partnership or a Trust will not have to pay tax themselves and thus we don’t need to account for it. The profits derived in these structures are split to the partners or allocated to the beneficiaries. They are the ones who will pay tax, not the entities themselves. So, no provision or journal is required.
For Companies and Sole Traders, it is a little more complicated.
Take a small family owned Company for example.
- Teller Morrow Pty Limited operates an automotive repair shop;
- In the 2017 financial year, it is expected to have net profit of $50,000.00;
- There have been no Income Tax Instalments paid in advance;
- The Company Tax Rate is 28.5% and thus the projected tax payable will be $14,250.00
We account for this by the following end of year journal entries:
Debit Income Tax Expense $14,250.00
Credit Income Tax Payable $14,250.00
When the refund, we do the following:
Debit Income Tax Payable $14,250.00
Credit Bank Account $14,250.00
In the event that income tax instalments of say $15,000.00 have been paid in advance we account for the expected refund by doing the following journal:
Debit Income Tax Expense $14,250.00
Credit Income Tax Payable $14,250.00
When the refund is paid to the company paid, we do the following:
Debit Income Tax Payable $14,250.00
Debit Bank Account $750.00
Credit Provision for Income Tax $15,000.00
Now let’s look at a Sole Trader / Individual’s treatment.
- Bobby Munson operates a small Ice Cream Shop called Samcro Sweets;
- In the 2017 financial year, it is expected to have net profit of $50,000.00;
- Bobby also has a rental property that has made a $10,000.00 loss;
- He made $6,000.00 in interest on his bank accounts;
- He has a share portfolio that generated franked dividends totalling $3,000.00;
- He worked part time for his friend Nero and made a salary of $15,000.00 and had PAYG tax withheld of $2,000.00
How do we account for this? Well as a sole trader, Bobby needs to include all these elements in his personal tax return. A sole trader’s income tax is calculated based on the lot, not just the business.
Sure, we know that his business made a profit of $50,000.00 but as a sole trader, what about the impact of everything else?
The short answer is that it is not common practice for accountants to provide an end of year journal for the income tax reconciliation for sole traders because the income tax generated by the business and the sole trader’s other activities are one in the same.
However, it can be done.
Sole Trader clients will occasionally request that their tax liability be dissected to show the impact each different component (interest, dividends, rental property) has. As a result, a journal entry can be provided to show the tax position on the sole trader’s business.
Maybe Ben Franklin was more right than he knew, and as a bookkeeper, you may feel that these taxes and end of year journals will be the death of you. Or in accounting terms, cause you to become 100% depreciated.
If we can help you with any further questions or assist in these end of year journals, please feel free to start a conversation.