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Articles in Category: Consulting

Tax and small business owner remuneration

on Saturday, 08 April 2017. Posted in General, Consulting, Tax

The tax consequences of profit extraction by directors of owner managed companies.

Tax and small business owner remuneration

 

Introduction

A question that we often receive from directors is how to compensate yourself if the company is owner managed. In other words a business where the owners are the directors and have discretion in how they are going to structure their own remuneration, or how they are going to extract the profit from the company.  Let us explore three possible scenarios.

1. Building up a loan account

We often find that the owners draw money at will and build up a loan account with the company. Some directors are under the impression that this method attracts no tax. They are wrong. 

The first factor to consider here is the interest rate that the company is charging the director. In most cases this is 0%. In normal circumstances a company would charge an interest rate to someone it lends money to. Thus in this case the 0% or lower than market related interest rate is directly attributed to the fact that the director is a connected person to the company. In other words the director is receiving a benefit due to his / her employment or connection with the company. This  equates to remuneration and as you know remuneration is taxable. 

The way the income tax act deals with this situation is by a concept called a deemed dividend. The logic behind this is that the interest free \ low interest loan to the director is (substance over form) the same as a dividend. At the tax year end the balance of the director’s debit (owing to the company) loan account is used to calculated the deemed dividend. The difference between the interest rate that the company charged the director and the official interest rate (repo rate plus 1%) is used to calculated the amount of interest that “should” have been charged were the director not  a connected person. The balance times the interest rate that “should” have been charged is now deemed a dividend and off course dividend tax (currently 20%) is payable on this amount.

Let me illustrate by way of an example:

Director A of company ABC has a loan account debit balance with the company at year end of R100 000. The company did not charge any interest to the director. The current repo rate is 7% and thus the official interest rate is 8% (7% + 1%). 

Thus the deemed dividend is R8 000.00 (R100 000 x 8%) and the dividend witholding tax on that is  R1 600.00 (R8 000.00 x 20%).

Some directors might think that this is not a bad deal R1 600.00 on R100 000 cash withdrawn from the company. They are again wrong. Remember since the loan is of a capital nature it does not get deducted on the income statement as for example a salary, thus it does not decrease your taxable income. So in effect you can argue that the company pays 28% income tax on the R100 000 (since this would have been deductible if it was a salary. Already you are at R28 000 (R100 000 x 28%) plus R1 600.00 deemed dividend which is R29 600. Again the director might think that this is better than a normal dividend of R72 000 (the after tax profit R100 000 - R28 000) which would have resulted in R14 400 witholding tax (R100 000 x 20%) plus the R28 000 income tax which would which would have resulted in a total of R42 400.

In the loan account situation your total tax was R29 600 at an effective tax rate of 29.6% (R29 600 / R100 000) and in the dividend situation your total tax was R42 400 at an effective tax rate of 42.4% (R42 400 / R100 000). Well that might seem that the loan account is the better option, but the differentiating factor is that the same deemed dividend will be charged on the same R100 000 (plus interest from previous year) in the next year. In other words your effective tax rate in the loan account situation keeps on growing each year that the loan has its balance outstanding. Effectively the director is being taxed multiple times on the same initial R100 000.

2. Paying a dividend

This was basically covered in the previous section. If the director declares a dividend to him / herself the effective tax rate is 42.4%. Simply due to the fact that the company pays 28% tax on the profit and the director pays 20% dividend tax on the dividend allocated from after tax profit.  

An example:

The company has R100 000 taxable income (which the director would like to allocate to him \ herself. Thus the company pays R28 000 income tax and the after tax profit is R72 000 (R100 000 - R28 000). The company can declare a dividend on the after tax profit to the director which results in R14 400 dividend witholding tax (R72 000 x 20%). In other words the company and director paid a total tax of R42 400 (R28 000 plus R14 400) which is an effective percentage of 42.4 (R42 400 / R100 000).

3. Paying a salary

The director can also pay him \ herself a salary. For some reason many directors are under the impression that this is the least tax efficient. In many cases this is actually the most tax efficient.

The tax rate off course varies based on the total salary that the director receives from the company. However the effective tax rate is less than 42.4% (as with the dividend) for a total annual salary of up to R5 961 949 (based on the 2018 individual tax rate table, a corporate income tax rate of 28% and a dividend witholding tax rate of 20%).

Conclusion

Many factors have been left out for simplification in the discussion above. My advice would be to always contact a tax professional to evaluate your specific situation. If I had to make a rule of thumb, I would say it is simple, if your company’s taxable profit that you would like to extract is less than R5 961 950 (for 2018 tax year) extract the profit by way of a salary, if it is more than R5 961 950 (for 2018 tax year), extract the R5 961 950 as a salary and the amount above that as a dividend. What about loan accounts? I would say, stay away!

Contact us for assistance: https://www.chconsulting.co.za/contact

 Author: Chris Herbst

Business Valuations

on Wednesday, 08 April 2015. Posted in General, Consulting

Business valuations: The art of the science - Part 1

Business Valuations

Image license: https://creativecommons.org/licenses/by/2.0/

Image title: Plan and Valuation of Pews

Business valuations are a combination between well-developed financial principles (science) and professional judgement (art). From the onset there is one principle that needs highlighting:

The best form of a business or any other valuation is the price that a willing buyer will pay to a willing seller in an arm’s length transaction. Please keep this principle in the back of your mind while reading the rest of this article.

It does not really matter what a business is worth on paper if no-one is willing to pay that amount. The danger of business valuations are that one can easily inflate the value of the business with ambitious future projections. Before we explore this statement, the discussion of some of the popular business valuation approaches will lay a foundation.

The Discounted Cash flow (DCF) and Net Present Value (NPV) methods.

These two methods are discussed together as they are closely connected. The basis of the DCF method is the calculation of the present value of future income. The backbone of these two methods is to take the future profits/cash flows that the business will generate and then determine what these profits/cash flows are worth today.

To illustrate by example:

Company A will generate profit of R10 in year 1, R20 in year 2 and R30 in year three. To determine the NPV of these profits you need to discount the profits to today’s value. All that this means is that you should look at what these profits are worth in today’s money. To simplify, say investor X had two options (ignore inflation for simplicity):

  1. Invest her money in a risk free fixed deposit at Big Bank that earns 10% interest per annum
  2. Invest her money by buying 100% shares in Company A

If she were to choose option 1 and invest R100, her investment after year one would be worth R110 (R100 x 10% = R10, add the R10 to the original investment of R100). After year two her investment would be worth R121 (R110 x 10% = R11, add the R11 to the value of the investment at the end of year one). Following the same logic the investment would be worth R133.10 at the end of year three. Thus she could increase her capital by R33.10 without taking any risk (not that a risk free investment is really possible, but that that is a topic for another day). Based on this, one can safely say that she would want to earn at least 10% on the investment in Company A. However by investing in Big Bank she does not take on any risk, with Company A she could lose all her money. Thus naturally she would expect additional return for the increased risk (higher risk = higher return). To determine the additional return for the additional risk, one would look at the Beta, Systematic and Unsystematic risky premium for the investment. I will return to this at a later stage. For now assume the additional reward for the additional risk is 5%. Thus a fair rate of return for investing in Company A would be 15% per annum.

You will recall that in order to get from the initial value of the investment in Big Bank to the value after year one, the calculation was ((R100 x 10%) + R100) = R110. An easier way to write this is simply R100 x 1.1 = R110. Thus to now discount the investment from year 1 to today, one needs to do the reverse of the above. That is R110 / 1.1 = R100.00.

Now you know how to discount the future profits of Company A:

Year 1: R10 / 1.15 = R8.69

Year 2: R20 / 1.15 = R17.39, but now we have only moved from year 2 to 1. Thus we must also move from year 1 to year 0. R17.39 / 1.15 = R15.12 (you can also write this as R20 / (1.15)^2, where ^ is “to the power of”)

Year 3: R30 / (1.15)^3 = R19.72

Thus the total value of all three year’s profits discounted to today is R43.53 (R8.69 + R15.12 + R19.72).

If we assume the company will only exist for three years then we can say that the value of the company to this investor is R43.53. Thus if the investor offer R30.00 for the company there will be intrinsic (built-in) value of R13.53. If the seller is willing to accept a price below R43.53 it will be a worthwhile investment for the investor.

At this stage there should be two things bothering you:

  1. The influence of our fair rate of return/discount rate ( 15% in example )has on the valuation, or how we determine the correct rate
  2. How long we assume the company will exist (three years in the example)

These points will be address in a follow up to this blog.

Author: Chris Herbst

Contact: https://www.chconsulting.co.za/contact

How to pay yourself if you are a small business owner – Part 1

on Tuesday, 13 January 2015. Posted in Accounting, Consulting, Start-ups, System Implementation, Tax

Actual transfer of the cash from business to owner

How to pay yourself if you are a small business owner – Part 1

Photo title: Money being cut into many pieces. Source: TaxCredits.net

Licence: https://creativecommons.org/licenses/by/2.0/legalcode

What is the most tax effective and correct way to get the profit of your business in your personal bank account?

This is a problem that numerous small business owners struggle with. I will attempt to clarify some of the issues relating to this, give advice on the correct practical way to handle the profit extraction and the tax implications thereof. This will be done in a series of blog entries. At the end of each entry I will give the business owner a practical change to implement in his/her business.

Sole proprietor

I would first like to clarify that if the business trade as a sole proprietor, I will still refer to the business as a separate entity. Substance over form, the business is still a separate entity although it has the same legal personality as the owner.

Sole proprietors frequently have one bank account for their business and their personal account. This causes a lack of segregation and at the end of the day there is no transfer of cash from the business to the owner, as the cash is already in the account of the owner. A situation like this makes it very difficult to keep track of how much money the owner is actually receiving from the business.

Although this was not possible at all banks in the past, it is now possible to open a business account when the entity has a legal form of sole proprietor. I have verified that is possible at FNB, I am not sure about the other major banks. If your current bank does not allow this, they will allow a cheque and savings account or an additional savings pocket. You can then use one of the accounts for business and one for personal.

The bottom line is that there needs to be an actual transfer with a paper trail from business to owner.

Close corporation or Private Company

This type of legal entity will have a separate bank account in its own name. The danger here is that the owner uses the business account to pay for personal expenses. This is not illegal, but it creates a lack of segregation and increases the administrative burden of processing the bank account of the business in the relevant accounting software. If this method is used the loan account of the owner (which will be debited with each personal expense) will give rise to a deemed dividend if it has a debit balance, this will be discussed under the tax consequences.

Also here I strongly recommend that there is an actual transfer from the business account to the personal account of the business owner.

Practical change to implement for part 1

Whether you are a trading as a Sole Proprietor, Close Corporation or Company, you need to implement discipline in your business by doing an actual transfer from the business account to your personal account whenever you extract profit to yourself. When you do this transfer on your internet banking, clearly label the description something like “Profit Distribution – Name – Month” or “Salary – Name – Month”.

Author: Chris Herbst

Contact: https://www.chconsulting.co.za/contact

Business growth and good coffee takes time

on Tuesday, 02 April 2013. Posted in General, Consulting, Start-ups, System Implementation

Business growth and good coffee takes time

Why do some small businesses not grow? I believe the main reason is that these small businesses wants their growth the same as their coffee. When their budget is tight they are indeed prepared to make the coffee themselves, so they make instant coffee. When funds become available they buy freshly roasted coffee from a drive through, instantly.

My point is that whether these small businesses have funds or not, they want growth to be instant. Some of these small businesses do implement measures for growth and then they quickly realise there is no instant results. So in most cases the measures fade away because no results are visible. Most real sustainable growth happens over time, similar to planting a seed today and only harvesting the crop in a future season and the crop may fail a few times along the way.

Being a coffee enthusiast myself, I can tell you that a good cup comes at a cost. I prefer to buy my beans from the roaster or a retail outlet that is directly affiliated with a local roaster, meaning they get freshly roasted coffee at least weekly. I do not buy the beans that are on the shelves on most supermarkets as they are in most cases guaranteed to be stale after a month from roasting date. Further I do not buy ground coffee as with that the freshness along with the taste is basically lost 3 minutes after grinding it. I buy beans and grind it myself, preferably with a hand manual grinder. An electric grinder is fine if it is a decent burr grinder, but the decent ones are usually the industrial ones and are rather expensive for the home user. You have the electric blade grinder as a cheap alternative but it gives you an inconsistent grind (coffee particles vary in size) and the heat of the rotating blades damages the coffee's taste. There is a reason to this madness, if done correctly you will get the most amazing and authentic coffee taste. Coffee should never be bitter. And you should never kill coffee with sugar! The reason people drink sugar in their coffee is exactly because it is prepared incorrectly and then tastes bitter.

Please reread the above paragraph with instant versus patient, cheap versus quality and healthy versus unhealthy in the back of your minds. Now compare the analogy to your own business and measures for growth, if any.

I want to communicate to small business owners that they must not give up on implementing strategies to grow, rather develop patience and a long term view. Be relentless in implementing small additions to your main vision of growth and direction, but remember it takes time, so also be relentless in developing patience.

http://www.chconsulting.co.za/contact

New financial year - time to get your house in order?

on Thursday, 28 February 2013. Posted in Accounting, Consulting, System Implementation

Follow up on the Small Business Sins series - Implementing a business system

New financial year - time to get your house in order?

We are entering a new financial year for the majority of small business owners and individuals. In follow up to my previous blog regarding the small business sins, I believe a new financial year is a great time to start fresh.

For the majority of small business owners, time and money is a scarce resource. Hence implementing a proper structure and system is not at the top of their priority list. Most only spend some resources on complying with statutory obligations for SARS and CIPC, because they have to do so by law.

There are some profound underlying changes that occur when you get your house in order, but for now let’s focus on some of the more obvious ones. The typical small business owner does not want to spend time on creating a structure for their business because they perceive this as a waste of time. The reason they believe it is a waste is that they think they should rather spend their time on making more sales or getting more clients or to just do what they have to do to survive.

Make no mistake, the majority of small business owners work very hard and it is understandable that they may make this critical error in underestimating the value of order because they focus on daily survival. However order is essential for creating spare time in the future. It may seem the other way around at first when you are implementing a new system, but be sure if it is a solid logic system, you will reap the benefit in saving time in the future.

Once you reach the stage where your system takes on maturity and start running on its own, you will be able to start breathing more and returning to your original role of business strategist rather than operational slave. Remember that time when you started your business, your thoughts were occupied with questions such as what will work? What if I change this? How will this influence that? Now you have become operationally enslaved with questions such as: What time do I have to be there? How am I going to remember to do that? When do I have to pay this? What type of part did he want? What was it Mrs Jones ordered? How can he say that is bad service?

How do you ever want to grow without order as a foundation?

Is it time to get your house in order?