Getting paid from your own business

Feb 2, 2022 | Articles, Tax

Which is the most tax-efficient?  Salary?  Perks?  Dividends?  It depends…

 

STEVEN JONES

BACK WHEN I was still running a full-time accounting and tax practice, one of the questions that my clients asked most frequently was how they could be remunerated from their business in the most tax-efficient manner.

Now make no mistake—if income is earned, there will be tax to be paid.  To do otherwise would be tantamount to tax evasion.  That said, there are some planning opportunities available to business owners that are legal, legitimate, and can certainly save some tax for the business, its owners, or both if structured correctly.

For this kind of tax planning to work, there needs to be a degree of legal separation between the business and its owners—in other words, they need to be separate legal entities. This would therefore rule out sole proprietors and partnerships, given that the owner(s) of the business are taxed on the profits in their personal capacity anyway.

However, if your business is housed within a separate legal entity such as a private company, opportunities arise from the fact that corporate structures are taxed differently to individuals.

One obvious difference is that companies are taxed at a flat rate of 28%, while individuals are taxed on a sliding scale based on their taxable income at rates ranging from 18% to 45%. Understanding how the different tax structures work could enable you to structure your remuneration in a tax-efficient manner.

This article is by no means an exhaustive list of all tax-planning opportunities available to business owners, but is presented as a starting-point for opening up discussions with your accountant or tax practitioner.

Salaries
If you’ve been slaving away around the clock to get your company off the ground, it’s reasonable for you to want to reap the fruit of your labours. Given that directors are regarded as employees for tax purposes, it is perfectly legitimate for the company to pay a salary to their directors for services rendered. As is the case for salaries and benefits paid to other employees, the company can claim a tax deduction for such payments to their directors.

Carefully calculating the difference in tax rates between the company and its directors will allow for salaries to be paid in the most tax-efficient manner. For example, suppose that the company pays its director (who is a 100% shareholder) an annual salary of R120 000. The company gets a tax deduction for this payment, thereby reducing its tax bill by 28% thereof (i.e. R33 600).

However, if this is the director’s sole source of income, their personal tax liability on this amount (applying the tables for individuals and the primary rebate of R15 714) is R5 886. Looking at the company and its director combined, the payment of the salary in this manner has achieved a tax saving of R27 714.

Of course, as the amount of salary increases, the individual moves further up the tax tables and the tax differential reduces. However, assuming no other income earned by the individual, paying a salary makes sense on the face of it up to the point where the individual’s average rate of tax is below 28%.

At least, that would be the case if dividends were not subjected to a 20% Dividend Withholding Tax. This fact complicates the calculations somewhat, as we will see in the next paragraph.

Dividends
When I first started my articles back in the early 1990s, there were no dividend withholding taxes levied on companies. This made the calculations fairly simple.

To use an example based on the tax rates applicable in 1990, when the corporate tax rate was 50% and the top marginal rate for individuals was 45% (kicking in at R54 000 per annum), it was a no-brainer—you took the salary.

The reason for this is that while a salary payment would qualify for a tax deduction in the hands of the company, dividends are paid out from after-tax income. So it doesn’t take a rocket scientist to work out that the company’s tax bill is reduced by 50% of the salary amount, while the recipient will be taxed at no more than 45% thereof (assuming that their other income exceeds R54 000).

Add into the mix the fact that directors’ salaries weren’t subject to PAYE back then, you end up with a scenario where not only could shareholders save some tax, but with some careful structuring (e.g. by making the company’s tax year-end 31 March and paying the full salary during the last month), the eventual tax bill could be deferred by the individual could be deferred by around 18 months!

As you can well imagine, it didn’t take too long for National Treasury to start closing these loopholes—one way being to require directors to be provisional taxpayers, and another being to make directors’ salaries subject to PAYE.

Since then, personal tax rates have effectively reduced quite significantly. While the top marginal rate is still 45% (having gone as low as 40% during the early 2000s before creeping back up to its present level), the income at which it kicks in is far higher in 2021/22 (at R1 656 600) compared to R54 000 in 1989/90! Yes, I know that inflation has distorted this figure, but if the 1989/90 threshold were to be inflation-adjusted to 2021/22, the threshold at which the 45% rate kicks in would have been R421 800.

Corporate tax rates have also been reduced from 50% in 1989/90 to 28% today (set to reduce further to 27% for years of assessment commencing 1 April 2022), although this is somewhat counterbalanced by the Dividend Withholding Tax payable by the company at 20% of the dividend. This means that if a company were to pay out its entire after-tax income as a dividend, the effective rate of tax will be 42.4%.

So which is more tax-efficient?
I have compiled a table covering a range of salaries from R120 000 per annum right up to R10 million, using the same after-tax cost for the company for both a salary and a dividend payment, having accounted for the different tax treatment. If you are a nerd like me who likes to crunch the numbers, please e-mail us at info@bellanmedia.co.za and we’ll gladly send you the table.

For normal people, suffice to say that being paid by way of a dividend only makes sense once the individual’s average rate of tax on the same income received as salary exceeds 42.4%. The cross-over point in favour of dividends is reached just shy of R6.7 million per annum.

I’m pretty sure that taxpayers earning these levels of income will have far more sophisticated tax planning structures in place than what I’ve presented here. As for us mere mortals, the answer is simple: Take the salary!

Other tax-saving opportunities
There are however other opportunities for business owners to save tax, such as:

  • Fringe benefits where the taxable value is less than the cost. There may however be specific eligibility rules, for example how employer-provided housing is taxed.
    Mobile phones and computer equipment. No taxable value is placed on the use of such assets provided that the employee uses them mainly for the purposes of the employer’s business.
  • Interest on shareholder loans. A reasonable, market-related interest rate is deductible by the company, while the shareholder providing the funds can receive interest up to R23 800 per annum tax-free (R34 500 per an-num if they are aged 65 or older).
  • Final considerations
    Bear in mind that any payment to employees (including directors) must be reasonable in relation to the business size and the duties performed. While determining what is ‘reasonable’ is subjective, paying someone R1 million per annum to perform receptionist and general office duties is likely to raise some eyebrows at SARS.

Salary and benefits to directors should be treated in the same manner as one would for an unconnected employee. The key is consistency, underpinned by a service contract and written remuneration policies.

Failure to bear these aspects in mind could result in SARS disallowing the deduction in the company return, but still taxing the individual on the income!

Steven Jones is a registered SARS tax practitioner, a practicing member of the South African Institute of Professional Accountants, and the editor of Personal Finance and Tax Breaks.