Are you in business for yourself? In this video, we explain how income tax works. You’ll also find out if you have to pay provisional tax, which is a way of paying your income tax throughout the year.

Meet Carolyn! She’s a photographer, who’s just started working for herself as a sole trader. In her first year, Carolyn made gross sales of $98,000. When you file your tax return, you record your gross sales, then deduct your business expenses. Carolyn’s business expenses for the year came to $62,000. After deducting her expenses, Carolyn has made a net profit of $36,000. You pay income tax on your taxable income. Your taxable income will be your net profit plus any other income you might earn, like a salary or wage.

As an individual your taxable income is split into layers, and each layer is taxed at a different rate. Let’s see what this means for Carolyn. Remember, she earned taxable income of $36,000. The first $14,000 is taxed at 10.5%. So she’ll pay tax of $1,470 on this part of her income. The remaining $22,000 is taxed at 17.5%. So she’ll pay tax of $3,850 on this part of her income. Carolyn’s total income tax for the year is $5,320. That’s how income tax works for individuals in business. For companies, it’s a bit different. A company’s taxable income is taxed at a flat rate of 28%. So that’s income tax!

Now let’s look at part two of this video, provisional tax. Provisional tax isn’t a separate tax – it’s a way of paying your income tax throughout the year. In general, you pay three instalments of provisional tax. At the end of the tax year, when you file your income tax return and work out your tax payable, you can deduct the provisional tax you paid earlier. In other words, provisional tax helps you “spread the load”.

Who has to pay provisional tax? Anyone with residual income tax to pay of more than $2,500. Residual income tax is tax on taxable income less any tax credits you may have. For example, P.A.Y.E. on your salary or wage. There are two main ways to calculate provisional tax: the standard option and the estimation option.

If you choose the standard option, your provisional tax equals your previous year’s residual income tax plus 5%. Carolyn’s income tax payable was $5,320, so her provisional tax for her second year is $5,586. She divides by three to give the amount of each instalment. That’s how you calculate your provisional tax using the standard option.

When might you choose the estimation option? If you think your income for the coming year will drop. Suppose Carolyn has a baby, and she plans to spend less time working in her business during her second year. Because she expects her income will drop, she chooses the estimation method to calculate her provisional tax. After preparing a budget, Carolyn works out her taxable income in Year 2 will be $23,000. Tax on $23,000 is $3,045. Carolyn divides by three and sees that for her second year of business she’ll need to pay three provisional tax instalments of $1,015. Please estimate your provisional tax carefully. Interest and penalties may be charged if your estimate is too low.

When do you pay your instalments? Let’s look at a timeline. If you have the standard balance date, your first instalment towards your tax for Year 2 must be paid by 28 August. Your second by 15 January. 7 February is the due date for your end-of-year income tax for Year 1. Your third and final instalment of provisional tax must be paid by 7 May. Please include your provisional tax payments in your budget, so you can pay in full, and on time. Interest and penalties may be charged on any late payments. If you can’t pay, contact us before the due date.

Visit our website for more information. You can read our Provisional tax guide or search for a specific topic of interest. Our tax calculator can work out your income tax for you. Go to business.govt.nz to access further tools and resources for starting in business.