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:

1. When it comes to getting money from my business, I have two options:
   1. Operating as myself, where all profits are taxed in my hands.
   2. Operating as a company, where all profits are taxed in the company (and then declared as a dividend to me).
2. 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%.
3. Companies are taxed on their income at a flat 28%.
4. Dividend declarations to shareholders are subject to a 15% withholding tax.
5. What this amounts to:
   1. Extra profits taxed in the hands of the sole proprietor get taxed at 40%.
   2. 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%]
6. 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:

1. “Because every tender document I look at demands that I submit my company registration documents and my BEE credentials” and
2. “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:

1. Let’s say that I’ve earned R1 million over and above the R673,000 limit in any given year.
2. I can take the after-tax amount, and invest it in an investment that’s earning 10% per year for the next ten years.
3. I have two options:
   1. 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.
   2. 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.
4. Two other things to bear in mind (because investments earn capital returns):
   1. Individuals pay capital gains tax at 13.3%
   2. 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:

1. Incorporate as soon as it makes sense for you to register yourself for VAT (for the input tax saving)
2. 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.