Every year lawyers in practice on their own account, along with any self-employed person, need to meet tax obligations. With some planning and preparation, meeting these obligations can be relatively stress-free.
There are two simple ways for lawyers to tackle this: by putting a set amount of money aside during the year (such as the appropriate amount each time a client pays an invoice), or to get an accountant to look after your tax affairs.
Large law firms tend to set up two bank accounts for each partner. Around two-thirds of the partner’s earnings goes into one account, and about one-third goes into a “tax account”.
Although the money in the tax account can be accessed at the partner’s discretion, the firms tell their partners this is not only to be used for tax-paying purposes.
If the practice runs a trust account, the tax monies should not be held in the trust account. This is to ensure compliance with regulation 8 (restriction on use of trust accounts for personal transactions) of the Lawyers and Conveyancers Act (Trust Account) Regulations 2008.
Failure to put a plan in place can result in lawyers playing catch-up and potentially incurring late payment penalties and interest.
Rule of thumb
Meredith Connell partner Nick Malarao is a tax specialist and a member of the Tax Working Group, and has acted for the Inland Revenue concerning lawyers with tax issues.
“When we have solicitors leaving Meredith Connell to become barristers or sole practitioners, I always tell them ‘get a good accountant. Don’t try and do it yourself. Think about putting a third of your gross revenue aside. That’s a rule of thumb, but I think it’s probably what you’ll need’,” he says.
It is important to put money aside right from the beginning.
“In your second year, you have to pay income tax for the previous year, as well as having to pay provisional tax for the year you are in,” Mr Malarao says.
“That is where a lot of businesses fail and they could avoid this by planning a bit better and getting good advice.
“By putting money aside right from the start, you don’t end up paying your first year’s tax plus provisional tax from your second year’s income.
“Lawyers often think that they are good with numbers. I don’t think they are,” he says.
“Having an external accountant brings discipline that may otherwise be lacking. It is a job best left to those who do it day in, day out, and the cost is worth it in my view.”
Unexpected absence from the practice
“The other thing I see quite often is when an illness has affected a lawyer. Whenever something like that happens, they struggle to keep their practice alive and compliance with the tax system becomes difficult,” Mr Malarao says.
“You may have to pay a lot of money for medical expenses, and that comes out of the money you would otherwise have to pay your tax, which you then have to find later.”
GST and PAYE
GST is another tax that some lawyers need to come to grips with.
“Lawyers can be tempted to go with a six-monthly filing option. In my view, that is a mistake, because that is a lot of paperwork to do, with the outcome that there might be a lot of tax to pay. I suggest a two-monthly filing option even if you qualify, or think you qualify, for the six-monthly filing option,” Mr Malarao says.
And for those with employees, he says all PAYE should be paid as soon as it is due.
“It is a criminal offence to knowingly not pay PAYE when it is due. The offence carries a maximum five-year term of imprisonment, for each instance of offending.”
What if you are struggling?
It is important to note that the vast majority of lawyers meet their obligations on time, says Richard Owen, Inland Revenue’s Lead for Small and Medium Enterprises.
“That said, lawyers are really no different from many of our customers and some do get behind on occasions,” he says.
Those lawyers who are salary and wage earners with PAYE deducted by their employer have less to worry about if they have no other sources of income.
However, lawyers who are recently self-employed are more likely to struggle initially with understanding their tax obligations.
“Inland Revenue recognises that any new business owner will be focused on building their client base when they’re starting out. Administrative tasks such as filing GST returns or employer monthly schedules can easily slip down the priority list,” says Mr Owen.
“But setting up systems and processes or even engaging a professional such as a tax agent is really critical to any new business getting their tax right from the get-go.”
For those lawyers who do find themselves in difficulty, Mr Owen recommends they make contact with Inland Revenue as soon as possible.
“In most situations we can work out a satisfactory solution that works for the customer and Inland Revenue, and ultimately helps them get back on track.”
Tax system improvements
Richard Owen says the department has introduced a number of recent initiatives to make it easier for people in business to meet their tax obligations.
One development is the accounting income method, or AIM, which allows businesses to pay tax ‘as they go’ when they make a profit.
This means tax payments are in line with a business’s cash flows from month to month, Mr Owen says.
“At the moment businesses have to pay provisional tax based on what their income was last year, or what they think they’ll do in the current year. That can easily result in an under-payment, meaning they’d be liable for penalties.
“And we know that many businesses intentionally overpay just to avoid the risk of penalties or interest, and then have to wait until the end of the year for a refund.
“AIM will eliminate the guesswork from paying provisional tax, which our customers have told us needed to be simpler and more aligned with their business cycles. It provides more certainty about how much tax is owed and makes managing cash flows simpler.”
AIM is for businesses with an annual turnover under $5 million and works through accounting software.
“You don’t have to be a tax genius to make the calculation,” Mr Owen says. “The accounting software does it all for you. And as long as you pay on time and in full, there’s no risk of penalties or interest.”