If you are a business owner from a regulatory perspective you have 3 possible options to pay yourself an income; a salary, a dividend or draw down on your shareholders’ loan account. In this video I will compare these three options and explain the different tax implications for each option. So, if you are a business owner or just inquisitive like I am, then this video is for you.
Just to be clear I am not offering any financial advice I am simply clarifying and explaining some basic business concepts for you to consider especially when engaging with your accountants so that you have a much better understanding of these concepts. I am aware that countries across the world have different tax rates and acronyms for their taxes, but in general many of the concepts remain universal. So let’s get into it.
As we all know, a company is a legal person while you and I are natural persons, which means that a company has the same rights and responsibilities as we do; for example it can own property, hire and fire people, sue and be sued as well as pay taxes just like we do. It is important for you to have a clear understanding of this concept as money often flows between you and your company and when it does, it can either be classified in 3 different ways, that is as a salary, a dividend or a shareholders loan and each of these option have different tax rates and implications.
Let’s start off with the shareholders loan account as many of our clients are unfamiliar with this concept. When you started your company it was effectively just a piece of paper and had no money. So to get your company up and running you would have had to use your own money to get things going. In fact, every cent of your personal money that you have put into the business can be claimed back from the company with interest. This money is called the directors or shareholders loan account and it is “tax free”.
Many entrepreneurs go as far as selling their own mobile phone and desktop PC’s to their company to create an even larger loan account. A large loan account is particularly useful as it gives you options to reduce both personal and company tax.
I said earlier loan accounts are tax free but they are not interest free, which means that interest must be charged on the loan. This is a double edge sword as on the one hand the interest is an expense in the company which is a good thing as it brings down the company tax liability, but at the same time the interest is seen as income in your personal capacity and therefore effectively increases your salary which could push you into a higher personal tax bracket. SARS publishes the interest rates that should be charged on loan accounts as can be seen here in Table 3. These rates are actually the bank repo rate plus 1%. Therefore, each time the repo rate changes the table adjusts. It is good to note that SARS does offer an interest exemption of R 22800 per year.
Beware that if you don’t charge interest on the loan, it is deemed to be a dividend and is taxed at a rate of 20% in South Africa.
The next option is a salary. As we all know, a salary is defined as a fixed regular income usually paid monthly. If your business can afford it there are definitely some benefits in paying yourself a regular salary. The first being that the salary is an expense for the company which means the profits in the company will be reduced by the amount equivalent to your salary bill. This will in turn result in the company paying less tax. Remember company tax is only paid on net profit after all the expenses have first been deducted.
But on the flip side you now will be liable for personal tax or PAYE as it is called here, as you are receiving a regular salary.
To choose the most tax efficient salary, you need to study this graph. Let’s take a look - Company tax is a fixed percentage of profit regardless of the amount of earnings. It is currently 28% and is depicted here by the horizontal blue line, with the x-axis representing money and y-axis the percentage tax you are liable for. The personal tax or PAYE tax is the logarithmic curved graph line starting from no tax for individuals earning less than R7,275pm and peaking at 45% tax for individual earning above R138,050pm after which it flattens out. Now assuming your business can afford it the optimal salary level in terms of tax efficiency is at the point where these two lines cross. For the 2022 tax year this amount is R60kpm. Any salary above this level depicted by the red line will attract more than 28% in PAYE therefore it would be wise to consider leaving the profits in the company and drawing more income from your shareholders loan account as it is tax free, except for the interest portion discussed earlier.