A friend called me a few weeks ago and enquired about starting a business. Advice was already obtained from a colleague who started their own business.
When I enquired if the person traded in their own name or in a legal entity, the answer I got was: “they just opened a business bank account”. I realized the person did not understand the difference between the different business forms. I will therefore attempt to give a brief summary. Please keep in mind that the type of entity is not an exact science. A governing body might have a specific requirement of the type of entity to be used (accountants, doctors and lawyers are an example, they can either trade in their own name or a personal liability company (ends with Inc. i.e. Brown Leaves Garden Services Inc.). Due to risk (or lack of it) one form of legal entity provides better “protection” than another entity.Trusts as a form of a trading legal entity are seldom used, mostly due to the fact that trusts are taxed quite heavily (40%) (For this example I ignored distribution to trustees that could reduce taxable income) and the administrative red tape. I will therefore focus on a sole proprietor vs. company as business entities.
I intend to give a high level basic outline of the differences.
I will break it down in the following areas:
– Definition
– Risk
– Tax implications
– Cost
The definition:
Sole proprietor – where a business is owned and operated by a natural person. So you will for example be Joe Soap trading as Brown Leave Garden Services (Afrikaans: “eenmansaak”).
Company – this will be a separate legal entity where the name will end in either Proprietary Limited (abbreviated as (Pty) Ltd) (also called a private company) or Incorporated (abbreviated as Inc.) (also called a personal liability company). The company will have shareholder(s) and director(s).
Risk:
In a sole proprietor should legal proceedings be made against the business, the owner will automatically be part of the legal proceedings (as they are one and the same legal person).In a private company (a (Pty) Ltd) should legal proceedings be made against the company, the shareholder will be “excluded”, but the directors will in all probably be held liable. So if you are shareholder and director, you will possibly incur higher risk. If you hold the shares of the company in for example a trust, but you are director, you will be liable as director. You can however mitigate some risk by not holding the shares in your own name. (Note: holding the shares in a different legal entity will have possible tax implications).You will need to consider the risk in the type of business you want to run, as this will be a contributing factor when deciding in which legal form you want to run your business.
Tax implications:
In a sole proprietor you will be taxed on the taxable profit (i.e. what is left of your income after deductible business expenses have been taken into account). This will be included in the owner’s personal income tax return. The sole proprietor/owner will be taxed on an individual’s sliding scale which vary from 18% to 45% (available on the SARS website). This sliding scale change on an annual basis. As a company is a separate legal entity, it will need to register for income tax (as a taxpayer) in its own right. In a company you will be taxed at a flat rate of 28%. Exceptions are if you qualify as a SBC with SARS, but more about that in a separate blog (see: How does a SBC work?), or select the option to use turnover tax.A few things to keep in mind with a company:If you trade in a different legal entity (like a company), you cannot just take money from your business as and when you like. You will need to declare a salary from the business to yourself (and the business will need to register for PAYE tax, run a monthly payroll and generate a payslip). The company need to submit an EMP201 return to SARS and make a PAYE payment to SARS monthly and submit an EMP501 return twice a year to SARS. The salary will be a tax deductible expense in your company (so this means it will reduce the amount of taxable profit in your company – therefore the company tax will be lower), but the owner will be taxed on the salary in his own name (at the same rate as if you were trading as a sole proprietor).
If you do not declare a salary to yourself there are two options to get money out of the company:
a) The amounts you take from the business will need to be allocated to a loan account. If you did put a lot of start-up capital into the business, the amounts you take out will initially be deemed as a repayment of the loan account, but once the loan is repaid and you still take money from the business, you will end up owing money to the business (also referred to as a debit loan account). SARS do not like the idea of debit loan accounts (as no tax was paid on the monies taken from the business) and SARS might consider this as a deemed dividend and tax it accordingly.
b) You can declare a dividend with the after tax profits (i.e. money left in the business after tax have been paid), pay 20% dividend withholding tax (DWT) on the dividend declared and get the money out of the business. DWT is a tax the shareholder (in this example the business owner) pay on the dividend, but the company deduct it on your behalf and pay it over to SARS. So the amount of dividend received by the shareholder will be “tax free” as the company already paid the tax on your behalf. The total tax rate (company tax + DWT) will in all probability be much higher than if you declared a salary to yourself.
Illustrative example:
Example 1: Profit before tax of R100,000
Sole proprietor:
SARS 2021 tax table for individuals (available on the SARS website):
Net profit before tax | 100,000.00
Individual income tax (as per the tax table) (18%) | (18,000.00)
Individual income tax | 18,000.00
Less primary rebate: | (14,958.00)
Tax payable | 3,042.00
Effective tax rate (R3,042 / R100,000) | 3.042%
Company tax (at flat rate of 28%):
Net profit before tax and director salary | 100,000.00
Director salary of 20% of above amount | (20,000.00)
Net profit before tax | 80,000.00
Income tax @ 28% | (22,400.00)
Profit after tax | 57,600.00
Now, let us assume you want to get the full amount out of the company (profit is also used for other purposes, i.e. To pay the capital portion of debt or increase assets (i.e. inventory)):
Dividend amount | 57,600.00
Less: Dividend Withholding Tax (DWT) @ 20% | (11,520.00)
Amount in shareholder’s bank account | 46,080.00
Tax on director salary of R20,000/year | nil
Total tax paid (R22,400 + R11,520 + nil) | 33,920.00
Effective tax rate (R33,920 / R80,000) | 42.4%
For the company/director salary calculation the total amount of tax paid will be R33,920 vs. R3,042 for the sole proprietor.
Please note: I have excluded a lot of other possible influencing factors, both for the company and the individual, as I just wanted to give an indication of the tax calculation. Your accountant will be able to help you with a detailed calculation of your scenario.
Example 2: Profit before tax of R1,000,000
Sole proprietor:
SARS 2021 tax table for individuals (available on the SARS website):
Net profit before tax | 1,000,000.00
Individual income tax (as per the tax table) (41%) | (322,771.00)
Individual income tax | 322,771.00
Less primary rebate: | (14,958.00)
Tax payable | 307,813.00
Effective tax rate (R307,813 / R100,000) | 30.78%
Company tax (at flat rate of 28%):
Net profit before tax and director salary | 1,000,000.00
Director salary of 20% of above amount | (200,000.00)
Net profit before tax | 800,000.00
Income tax @ 28% | (224,000.00)
Profit after tax | 576,000.00
Now, let us assume you want to get the full amount out of the company (profit is also used for other purposes, i.e. To pay the capital portion of debt or increase assets (i.e. inventory)):
Dividend amount | 576,000.00
Less: Dividend Withholding Tax (DWT) @ 20% | (115,200.00)
Amount in shareholder’s bank account | 460,800.00
Tax on director salary of R200,000/year | 21,042.00
Total tax paid (R224,000 + R115,200 + R21,042) | 360,242.00
Effective tax rate (R360,242 / R800,000) | 45.03%
For the company/director salary calculation the total amount of tax paid will be R360,242 vs. R307,813 for the sole proprietor.
Please note: I have excluded a lot of other possible influencing factors, both for the company and the individual, as I just wanted to give an indication of the tax calculation. Your accountant will be able to help you with a detailed calculation of your scenario.
Cost:
When you set out with your own business and you have limited funds, trading as a sole proprietor initially and “converting” (transferring the business) to a company should it later be necessary might be a good idea.
A sole proprietor might need to pay for an annual set of financial statements and submission of a tax return.
With a company there is the cost to set up a company, you pay when you change directors/shareholders, you pay annual CIPC fees and (like a sole proprietor) you also have to do a set of financial statements and submit a tax return.
Conclusion:
As can be seen from the above, it is quite a lot to consider. I suggest discuss the option of which entity to use with your accountant before you start a business. This can become a complex calculation (especially as far as the tax implications go). They will be able to advise on the implications and what will be best for your unique scenario.
