Tax Tuesday: The most tax efficient entities

De Wet De VilliersLatest, Tax Tuesday

Within the context of tax, an individual, a company or a trust can own property and earn income. This income could be trading profits, capital gains, dividends, etc. Holding assets in one’s own name is, obviously, the simplest and most cost-effective of these three entity types. That being said, the tax benefits linked to a trust or a company could outweigh the costs of a more complex structure.

So, when would a company be more tax-efficient?

Not when it comes to VAT, transfer duty or securities transfer tax. Here the tax regimes are pretty much the same for an individual, a company or a trust. Donations tax is levied at 20% for individuals (with an annual exemption of R100,000) and companies (with an annual exemption of R10,000).

Trusts are practically exempt from donations tax.

The two tax benefits of a company

The tax benefits a company can offer may be narrowed down to the following two benefits:

1.) A company is exempt from dividends tax (charged at 20%).

2.) A company’s income tax rate is only 28%. (The income tax rate of trusts is 45% and for individuals, it’s 31% to 45% when the individual earns more than R305,851 a year.)

Therefore, companies make for excellent short-term investment vehicles. They don’t pay tax on dividends received from shares. The profits from share, bitcoin or property trading are taxed at 28% max. The same would apply to income earned outside of share trading and the like.

The problem comes when the individual behind the business wants to access the company’s profits to buy a house or treat the family to a holiday. Those profits can be accessed by either paying a dividend to the shareholder (typically the individual running the business) subject to 20% dividends tax, or lend the funds to them, which would need to carry interest at prime less 250 basis points. This interest earned is subject to income tax at 28% in the hands of the lender, and cannot be deducted in the hands of the borrower, therefore tax ineffective.

Some people opt to go for a third route. Using the company’s profits, they pay out a salary to themselves, their children or spouses with no other income and therefore enjoy low tax rates. These salaries are often simulated, with the “employees” not contributing to the business at all. This type of misconduct opens itself up to an investigation by SARS.

What about estate duty?

For estate duty purposes the company as a tax-efficient entity makes no difference. It depends on who owns the company. If an individual is the shareholder, the value of the company still forms part of the individual’s estate. If a trust is the shareholder, then it doesn’t.

A common structure is for a trust to be set up and to run the beneficiaries’ operations and investments through a company in which the trust holds all of the shares. In this manner, both the estate duty and dividends tax or income tax rate benefits are achieved.

However, the situation becomes more complicated when individuals want to access the funds in the trust or company structure.

Enter capital gains tax

When it comes to capital gains tax (CGT), a company is probably the least tax efficient option as it’s subject to CGT of 22.4%. Individuals, on the other hand, may only be taxed up to 18%. Another benefit for individuals is when they own their primary residence. This gives them the added advantage of being exempt from CGT for the first R2m of gains realised on the sale.

A trust’s CGT rate is 36%. However, gains realised by a trust are normally distributed to South African resident individuals on which they’ll be taxed at 18%. Therefore, the 36% tax rate rarely applies.

For many, the estate duty benefit, coupled with the dividends tax and income tax rate advantages outweighs the additional CGT tax cost (which only arises when assets are sold) and the increased administrative cost factor. However, this will only be the case if a significant portfolio exists, or may potentially exist in future, to justify these costs.

In closing

The aim is to accumulate wealth in a trust-company structure from the start that won’t be accessed in the short-term. This is typically the best manner in which to utilise the company as a tax-efficient vehicle.

Tax Tuesday blog

Being tax efficient is an important part of great financial management. In this blog, a group of South African tax experts share their tips and explanations on tax issues. Learn everything you need to know about tax, from deductions you never knew about to retirement savings and capital gains. The first Tuesday of every month is Tax Tuesday. Don’t miss it!