DANIEL BAINES: Tax and expenses basics for business owners and individuals
A business deducts expenses and then pays tax, whereas an individual pays tax and then expenses are paid with after-tax money
The tax treatment of income in a business is very different to that of an individual in salaried employment. The general rule for a business is that expenses "reduce" income received and tax is paid on the reduced amount of income, whereas for an individual, income is received after tax has already been paid and then expenses are paid — that is, a business deducts expenses and then pays tax, whereas an individual pays tax and then expenses are paid with after-tax money.
Note that a business owner may not deduct personal expenses through his or her business — only certain business-related expenses are allowed to be deducted.
The effect of this is best illustrated by means of examples.
Example 1 - Tax paid by a business
• Income - R200,000
• Deductible expenses - R50,000
• Profit (taxable income) - R150,000 (tax is paid on the profit or "taxable income")
•Tax at 28% - R42,000 (R150,000 x 28%)
• After-tax profit - R108,000
In this example the business would pay tax of R42,000 on a profit of R150,000.
Example 2 - Individual in salaried employment
• Salary - R200,000
• Tax payable - R22,112 (including the primary rebate)
• After-tax pay - R177,888
The salaried employee would pay tax of R22,112 on a salary of R200,000.
Though this is less tax than the business, the employee still needs to pay all of his or her expenses with the after-tax money.
As a business owner there are a couple of ways to extract money out of the business.
This can be done by a salary — this salary would be a deductible expense for the business and the director would be subject to PAYE like any other employee.
Alternatively, the business owner can take dividends from the profits made by the company; or a combination of a salary and dividends.
A combination is more practical as the business owner would need a monthly income to live on.
It must be kept in mind that there is a dividends-withholding tax of 20% that must be paid to the South African Revenue Service (Sars) before a shareholder of a business can receive the dividend.
Let us continue with example 1 to illustrate the effect of this.
Example 1 (continued)
• After-tax profit - R108,000
• Dividends-withholding tax at 20% - R21,600 (R108,000 x 20%)
• Profit after dividends-withholding tax - R86,400 (R108,000 minus R21,600)
The business owner could receive a dividend of R86,400 in this example. As the dividends-withholding tax is paid before the dividend is paid out, the dividend is exempt in the hands of the business owner — in other words, he will not be taxed again on the R86,400 dividend. It must still, however, be declared to Sars as exempt income.
In the above example, the business owner has paid a total tax of R63,600 (this includes the R42,000 in company tax and R21,600 in dividends-withholding tax) on a profit of R150,000.
Though this sounds a lot, it must be kept in mind that the business expenses have already been paid.
It is thus difficult to properly compare the amount of tax paid by an individual in salaried employment and by a business as the expenses are paid by a business prior to paying tax, unlike an individual in salaried employment.
Note that if a business operates as a sole proprietorship, this has very different tax implications to those discussed above.
• Baines, a tax consultant at Mazars, is the author of How to get a Sars refund for small businesses