I see on the forum several ways of accounting for Income Tax. I would just like to clarify the best way for me from my current practice.
Each year I have to pay provisional income tax in advance based on the earnings from the previous year. Some of this is profit from the business and some from other non-business activities as I am a sole trader. Currently I have a separate bank account shown under the business into which every so often I transfer funds from the business account specifically to pay this tax. When I pay the tax I show a debit to a tax paid category on the P/L side. What I have realised is that the tax is not a business expense and should not be on the P/L side but somewhere on the left side of the chart of accounts under liabilities or equity I guess. Then I assume a journal entry should be made to separate out the non-business portion of the tax paid.
Can anyone assist and provide guidance on where the tax paid category should sit and my logic of using a journal entry or should I change this altogether?
For a Sole Trader These would be the entries in the Business file
Funds from business profits will be by Inter Account Transfer:
DR Business [Provisional] Bank Account
CR Business [Working] Bank Account
When you put funds from other sources into the Bus.[Prov.] Bank account it will be e Receipt transaction:
DR Business [Provisional] Bank Account
CR Capital Account (Equity)
When you pay provisional Tax it will be a Payment Transaction:
DR Capital Account (Equity)
CR Business [Provisional] Bank Account
Check your local tax law with the authority or a qualified accountant. In many jurisdictions, income of a sole trader/proprietor is taxed as income of the owner. In that case, no transaction relating to income tax has any place in the records of the business, either on the balance sheet or P&L statement. Net profit of the business is reported as individual income, and any advance payments or provision for income tax are part of your personal finances.
Many thanks, two options suggested. If I was to go with Tut and not show income tax on the accounts at all, I would still have some withholding tax that has been deducted from a minimal number of client invoices which I would need to remove as well from the business account and show with the provisional tax on the personal accounts. What would be the best way to do that?
Tax withheld and provisional tax paid should both be shown in the balance sheet. Assessed tax (at end of financial year) is the amount that will go to the P & L and always after profit before tax.
I would consider that, as a sole proprietor, the portion of assessed tax based on the business profit could legitimately be shown on your business P&L after profit before tax to show a profit after tax.
Having said that this is an accounting/tax question and is not related specifically to Manager and as such, to be sure, you need to seek professional accounting advice.
Even in case of sole proprietor I think that for financial management reasons it would be good practice to: 1) pay one-self a salary using payroll and 2) to have tax in the P&L after profit before tax. “Net-profit”, ie after-tax goes to retained earnings under equity in the Balance Sheet and the proprietor should be able to decide what proportion would be to repay possible company loans, used for further investment in the business or paid as divident. Whatever the particular country rules are on personal income tax can then be properly addressed. Meanwhile it give much clearer insight in how the company is doing and help with preparing financial forecasts and keep control of salary costs. It also will make it easier if in future one decides to change the company’s incorporation. Just my 5 cents.
My understanding is there are two divergent approaches
For a sole trader the business owner just pays personal income tax like any other person. There is no tax deduction for the business owners personal income tax so your accountant does not need to see it in the accounts. It is paid out of owners equity and need not be shown in the the business accounting software at all as described by Tut
For a sole trader personal income tax is likely to be the largest bill paid particularly if a business is growing. The bill can be paid almost 2 years after the income is earned. For a sole trader business working capital is the same thing as personal cash flow and if not adequately planned for, cash flow could result in insolvency or at least unexpected business costs. With this perspective sole trader income tax provisioning can be set up in an analogous manner to a company as described by AJD and PAYG Clearing - #24 by Patch
Both are reasonable approaches. With a stable income the benefit of option 2 is reduced as the tax authority already collects provisional tax (which is a reasonable estimate when business income is stable). Option 1 is less accounting work but option 2 is not that hard to do either.
Both are contrary to law or regulation in some jurisdictions. This is why qualified local advice is necessary.
Net profit is generally considered to be before tax.
Mmm, net profit as far as I am aware can be before and after tax. In Manager in its most basic setting in the P&L it is after tax…
As for paying one-self a salary and deduct it as a business expense as sole proprietor you are right that this mostly is not acceptable by tax authorities. One’s pay is indeed the profit (sales minus expenses) the business makes at the end of the year. The taxation in such case is after profit as technically a simple personal income tax. So possibly one more reason to establish and LLC even when small.
I am not sure where you get this idea. The default P&L statement in Manager is a very straightforward Income - Expenses = Net Profit. Modifying this to distinguish profits before and after income taxes can easily be done, but requires the addition of intermediate totals, new accounts, and possibly new groups to the chart of accounts. It also requires overriding the default Net Profit/Loss total that appears automatically as the final entry of the default P&L statement.
Sorry but disagree why would it state “Net profit” as automated part of the P&L resulting in retained earning in BS at the very end. I also would like to encourage you to Google about Net Profit so you can find out yourself that this can be before tax or after.
Because that is the most basic definition of net profit: all income less all expenses of the business. Remember that the original poster is a sole trader. So income tax is, in all likelihood, not considered by the relevant tax authority as an expense of the business, but rather as an obligation of the owner, based on all personal income. Income tax is generally considered to become an expense of the business when you move into corporate organizational structures. In those situations, the phrase net profit might refer to an after-tax bottom line. But that is not the situation that was raised.
I do not believe anyone is questioning the appropriateness of having a subtotal in Manager showing net taxable income.
However Manger can have as many subtotals as a businesses finds useful. Subtotals above net taxable income in the COA are useful to divide up businesses taxable income.
Accounts and subtotals below net taxable income are useful for untaxed expenses such as income tax, distribution of income and personal expenses. Displaying totals net of these expenses is also valuable for business management.
How specific the subtotal names need to be depends on what is displayed in the COA. What is the default or most useful to look at depends on what information a user is typically looking for, which is typically different for accountants and businesses owners.
@Pix can I ask what country you are in. I am a tax agent in NZ so if you are in NZ I can answer you
Ok so any income with withholding tax is already recorded with IRD so if you are filing straight off the profit and loss and you have added it as income be careful you dont declarer it twice.
so How I set up one client was like this
on the P&L
in the chart of accounts like this
that way I put down the untaxed income and still recorded the taxed income
I hope that helps its just the way I did it someone might have a better way
Example given by @Wornout demonstrates a method of displaying tax in the accounts. There will be any number of ways to display after tax items and that will be influenced by the requirements of each particular business.
Be aware though if assessed tax is less than tax withheld/provisional tax paid the refunded amount will need to be backed out of the profit and loss.
My preference is to record all pre-assessment payments on the balance sheet in an asset account (example called - Tax Prepaid) and once assessment has been made record the assessment by:
DR Assessed tax (on P&L)
CR Tax Prepaid (on BS)
The Tax Prepaid account (BS) will will end up with a debit or credit balance depending on whether an additional payment or a refund is due.
If a refund is due, when received create a receipt transaction;
CR Tax Prepaid
If additional payment is required, create payment transaction:
DR Tax Prepaid
I was not talking about provisional Tax I was dealing with his withholding tax that was paid by who he invoiced. They pay it directly to IRD
That’s fine. The same thing applies whether it is provisional tax paid or tax withheld.