A few weeks’ ago, I wrote a post on South Africa’s discrimination against entrepreneurs and small businesses (it was an Open Letter). Since then, I’ve been asked to write something about a choice that faces all entrepreneurs:
When do I stop being a sole proprietor and take the leap?
For most entrepreneurs, the argument goes something like this:
- When it comes to getting money from my business, I have two options:
- Operating as myself, where all profits are taxed in my hands.
- Operating as a company, where all profits are taxed in the company (and then declared as a dividend to me).
- Personal income tax is on a sliding scale – and once your annual taxable income gets over ±R673,000, you’re paying tax on the extra at 40%.
- Companies are taxed on their income at a flat 28%.
- Dividend declarations to shareholders are subject to a 15% withholding tax.
- What this amounts to:
- Extra profits taxed in the hands of the sole proprietor get taxed at 40%.
- Extra profits taxed in the hands of shareholder (through dividends) get an effective tax rate of 38.8%*
*[1-(1-28%)*(1-15%) = 38.8%]
- So therefore, I should only incorporate when my annual profits are over R673,000 – because then I’ll save 1.2% on my tax.
Now obviously, I have some thoughts on this: the main one being that a 1.2% tax saving is a very small tax saving, and companies are expensive beasts to keep in business.
The Costs of Incorporation
When you open a company, you’re suddenly going to find yourself:
- Paying fees to CIPC (both once-off and regular annual return fees)
- Paying bank charges on a separate bank account.
- Preparing two tax returns each time tax returns are due.
- (Probably) paying someone to keep track of where your accounts are at.
- Registering for PAYE, SDL, UIF and all the other employee-related expenses.
- Paying someone to submit the PAYE declarations by the 7th of each month.
- Paying PAYE (instead of paying provisional tax three times a year).
Easily, you’re looking at spending an extra R15,000 (after tax) annually in company-specific costs alone. And that’s not including the upfront investment of going through the incorporation and tax registration process (because either you do that yourself – which is laborious – or you pay someone to do it for you – which is at least another R15,000 right there).
To put that into perspective: whatever tax saving you make needs to be higher than the R15,000 after-tax cost of doing business. And remember how it’s only a 1.2% tax saving? What that means is – you’ll need to have earned an extra R1.25 million before you’ll start to save any money.
That is: you’ll need to be earning about R2 million a year in taxable income before the relative cost saving of a company becomes worth your while.
The Bad News
You’ll have had to register your company long before this point. I mean – practically, you’ll have had to. Because VAT.
VAT Rules require anyone with an annual turnover of over R1 million to be registered for VAT. And while I might like to register my personal self as a VAT vendor – if I reach the point of requirement, it’s probably just easier to register a company and keep it separate. Firstly, because I’m not sure if individuals are allowed to register for VAT (although I suspect they are) – but mainly, because SARS already treats VAT vendors as suspicious. If you’re trying to do it with your personal account, I expect that your entire life will be a VAT audit.
But there is some Good News
Registering for VAT means that you get to claim back the 14% VAT that you’d have paid on your expenses (basically, anything other than fuel and salaries). And that 14% saving sounds a lot more like a good reason for opening up a company. In fact, my gut feeling is that this is the number one reason for registering a company.
Actually, I’m lying. There is a list of contenders for the number 1 spot. Two prominent ones:
- “Because every tender document I look at demands that I submit my company registration documents and my BEE credentials” and
- “Because it’s cool to say that I own my own company”.
Anyway, the crux is: you almost never incorporate to save income tax – you incorporate to save on VAT. And if income tax was the only issue, then you’d probably be trying to stay a sole proprietor for as long as it’s not too big to handle.
But Wait – There’s More
I have one more observation to add.
Here it is:
People like to say that you don’t have to pay the dividend tax until you’ve declared a dividend to the ultimate shareholder.
So when you’re talking about effective tax rates of 40% and 38.8% – it’s important to recognise that there are some timing questions around that second one.
Let me give you an example:
- Let’s say that I’ve earned R1 million over and above the R673,000 limit in any given year.
- I can take the after-tax amount, and invest it in an investment that’s earning 10% per year for the next ten years.
- I have two options:
- Either I take the money out of the company as a bonus (taxed at 40%), and invest it*.
*Technically, I could also just take it as a dividend – but I’m trying to make a point here, so bear with me.
- Or I leave the money in the company (taxed at 28%), invest it from there, and then take the dividend tax hit at some future point when I’ve decided that I want the cash.
- Either I take the money out of the company as a bonus (taxed at 40%), and invest it*.
- Two other things to bear in mind (because investments earn capital returns):
- Individuals pay capital gains tax at 13.3%
- Companies pay capital gains tax at 18.67%
If I take the bonus:
- I’ll pay R400,000 in tax.
- I’ll invest R600,000 in the investment.
- In ten years’ time, that investment will be worth R1.56 million.
- There will be R127,000 owing in capital gains tax.
- So my net investment would be worth R1,428,000.
If I leave it in the company:
- The company will pay R280,000 in tax.
- It’ll invest R720,000 in the investment (sounds good so far).
- In ten years’ time, the investment will be worth R1.86 million (even better).
- There will be R214,000 owing in capital gains tax.
- So the company’s net investment would be worth R1,653,000 (still good).
- But there would also be a R248,000 dividend tax owing on that amount.
- So my net investment would be worth R1,405,000.
- Less than if I just took the money as a bonus (!).
And this makes sense with the math. The relative tax saving on income tax between a company and an individual is 1.2% in the company’s favour. The relative tax saving on capital gains tax between a company and an individual is 5.34% in the individual’s favour (and that’s before you take into account the annual capital gains tax exclusion that the individual gets).
The Moral of the Story
Actually, there are two:
- Incorporate as soon as it makes sense for you to register yourself for VAT (for the input tax saving)
- But when you’re investing, probably best to take the upfront dividend tax hit and just do it yourself (or, better yet, through a trust – but that’s a completely separate issue).
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.
Kosta November 6, 2014 at 08:59
Hey Jayson thanks for the great analysis.
FYI – sole proprietors can indeed register for VAT. I know a couple advocates who have done this after having crossed the R1m annual turnover, for example.
Regarding the one benefit of registering for VAT (namely the ability to deduct that 14% from expenses), this makes sense whilst your your operating margins are low – for example, if you’re a goods retailer. However for blokes like myself that sell software, and where our primary cost is salaries (with little other expenses), being able to deduct 14% from a minimal number of expenses isn’t much of a benefit. Strangely, however, being VAT registered does command a bit more respect from prospective customers, who would otherwise be fearful of dealing with a small company that has yet to hit R1m turnover – so there’s always that.
From an accounting / tax perspective, how does one distinguish between a bonus payment to the director of the company (which I see as just “extra salary”, taxed as normal income tax in the hands of the recipient) and a dividend? Especially since bonus payments also tend to be annual / semi-annual.
Awesome article as always. Keep ’em coming.Reply
Jayson November 6, 2014 at 11:14
Yes – there are definitely some qualitative benefits that come from being incorporated, being VAT registered and having a place of business. It confers legitimacy – almost as though you believe in yourself enough to become established. Or the government does. And I do love a signalling effect.
But service companies are not great from a VAT standpoint. Accountants, lawyers, etc. Athough it can make a difference when you start paying rental – and paying for the capital purchases. I guess what I’m saying is – there are ways to benefit from being VAT registered. Even if it makes more of a difference to those trading in goods.
Finally – on the bonus/dividend front – as far as I know, there is nothing to stop an owner-director from taking a dividend instead of a bonus. It’s really just a question of declaration. If you decide that you’re going to take something as a bonus, then you declare the bonus in the PAYE submission and it’s a bonus. And if you’d rather forgo the bonus and take a dividend, then the company declares a dividend, pays you the dividend and pays SARS the dividend withholding tax.
The distinction is more important in the listed company arena – where director is not necessarily a shareholder.
Does that help?Reply
Kosta November 6, 2014 at 17:25
Thanks for clearing that up, thanks!Reply
Kosta November 6, 2014 at 17:28
That would only make sense if your name was thanks.
Tom Hanks, T. Hanks, THanks, THANKS.
Alright back to work…Reply
JD November 6, 2014 at 10:41
Interesting article, as usual, but don’t forget to consider that when VAT registered you also need to charge Output VAT on all your turnover. Obviously you can pass this on to your customer who can claim is as an Input on their side if they are registered, but if you are in an environment where many of your customers are not VAT vendors, then you will whack them with an overnight 14% price hike which they might not be able to absorb.
The VAT registration process is a bit of schlep with SARS and does involve an interview in person at their offices where they will scrutinise the tax affairs of all directors and all other companies that those directors are involved in, so ensure all your tax affairs are in order before heading to SARS.
Kosta, a bonus is indeed extra salary, subject to PAYE and appearing on the IRP5 for the tax year, and therefore taxed in the hands of the individual. A dividend would need to be declared, SARS forms completed (I forget the reference number of those forms), dividends tax withheld by the company and paid over to SARS.
The dividend is technically taxable in the hands of the individual but as the company has already paid the tax on your behalf (much the same as PAYE is paid on your behalf) its and in-and-out on your tax return. Its a technical change from the old STC rules, but for the man in the street, works almost the same way.Reply
Jayson November 6, 2014 at 11:47
Thanks JD! Great points. I’m operating under the assumption that cresting the R1 million threshold usually implies a fair amount of VAT vendor transaction.
But also, if you’re not dealing with VAT vendors, then you could afford to lower prices (assuming that your costs are now at VAT exclusive amounts) – meaning that you won’t get the full benefit of the saving, but hopefully you’ll get some of it.
Obviously, each situation is different. But in general, I’d say that most companies are either quite neutral about being VAT-registered, or it works to their advantage. Which isn’t to say that there aren’t some people who’d be hurt by VAT – but they should be in the minority?Reply
Philip November 10, 2014 at 10:09
I thought that one of the main reasons to incorporate was legal indemnity in the case of bankruptcy. E.g. if the company fails then all the people you owe money to can claim all the assets of the company, but none of your own assets (e.g. you won’t be homeless). In the case of sole proprietorship you could lose your house.Reply
Jayson November 10, 2014 at 11:09
That’s definitely one of the main reasons to incorporate – but I wanted to talk about the tax benefits/costs of incorporating.
Also – smaller companies that have the tax benefit/cost conversation are generally not going to get the credit (because they’re too risky), and if they do, their directors/owners are going to have to sign personal guarantees (which negates the limited liability). But it certainly gets to be important as they grow.
Thanks for pointing it out. It’s a big one.Reply