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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

Comments (5)

  • Richard Conry

    09 March 2018 at 10:46 |
    Hi Chris
    You are basing this salary on the amount at which the effective tax rate breaks through the 42% rate. But over R1,5 million in salary the marginal rate of 45% kicks in.
    So on a salary of R5 961 950 a combined Corporate and personal tax liability of R4 240 001 arises. Declaring only R1,5 million salary and the balance as dividends, results in a total tax liability of R4 123 990 - a saving of R116 001. Using the 2018 tax year rates.
    Your comments?

    reply

    • Chris Herbst

      09 March 2018 at 11:12 |
      Hi Richard,

      Thank your for your comment. Your reasoning is incorrect, please see below:

      On a salary of R5 961 950 the personal tax liability is R2 527 867.5. The corporate tax liability is R0, since stripped with salary.

      Thus total tax liability of R2 527 867.5 Effective tax % of 42.4%

      On a salary of R1 500 000.00 the personal tax liability is R519 989.9

      You have stripped R1 500 000 as salary and therefore you need to strip the remainder R4 461 950 (R5 961 950 - R1 500 000) as a dividend.

      Dividends are paid with after tax profit, therefore to arrive at R4 461 950 after tax profit to distribute you would have paid R 1 735 202.78 corporate tax (R4 461 950 / 0.72 * 0.28).

      On the R4 461 950 dividend there is 20% witholding tax R892 390 (R4 461 950 * 0.2)

      Thus total liability of R3 147 582.68 (R519 989.9 + R 1 735 202.78 + R892 390). Effective tax % of 52.79%

      To strip the full amount with salary and zero dividends thus saving of R619 715.18

      reply

  • Cheryl

    05 May 2018 at 08:05 |
    Good day,
    I have 2 clients who have opened a company in the wife's names (for the purposes of a better BEE rating). They are employed elsewhere but have this operational business. They do not take a monthly salary / withdrawal of profits. However, whenever a good deal comes through, then they both withdraw funds. Under these circumstances, is it still correct to go the salary route? Should I rather suggest that they do a provisional estimation of what the annual withdrawal is going to be and just tell them to rather make it a monthly withdrawal in the form of a salary?

    reply

    • Chris Herbst

      07 May 2018 at 13:02 |
      Hi Cheryl,

      I would still recommend the salary route. However keep in mind if you only declare a salary in certain months that you need to file zero EMP201's for the other months and the normal UI19s. It is not needed to draw a fixed salary per month, you can declare only in the months that they will be drawing.

      Also keep in mind their other salaries and income when calculating the PAYE on the salaries in the relevant company so that you do not underestimate PAYE due to the wrong effective tax rate. The clients may then get a unexpected assessment when they file their personal ITRs.

      reply

  • Kerwyn Imrithchand

    11 October 2018 at 21:36 |
    Hi All. Please assist if you can. When a director has a debit loan account at year and we charge interest at repo rate do I only calculate interest on the total outstanding at year end or do I calculate interest on each amount taken by the director?

    reply

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