When to switch from running your business as a sole proprietor to a private company

By Ruan van Jaarsveld –  Manager, Hobbs Sinclair Advisory

Many South Africans have recently found themselves feeling the need to venture into business outside of the formal, corporate framework. Reasons for this vary from being retrenched from a position of employment to having to supplement employment income with another income stream.

Most new business ventures start out as sole proprietorships, the simplest form of business entity. But is a sole proprietor the best entity to run a small business and what should you consider before setting up a private company for your business?

Costs

The administrative costs to set up a private company and to maintain company secretarial as well as financial reporting requirements should not be underestimated.

A good benchmark is that at least 3% of a company’s annual turnover should be spent on maintaining and reporting of financial and administrative systems to ensure compliance and accuracy of the financial information.

Many small businesses see financial and admin requirements as an unnecessary evil and neglect this expense. This leads to inaccurate and outdated information being used in decision-making – a proven recipe for corporate suicide.

Risk and financial liability

In a sole proprietor structure, the business is run in the name of the owner. There is thus no distinction or separation between the assets and liabilities of the owner and the assets and liabilities of the business.

Taking on any form of risk in the furtherance of a sole proprietorship, whether that is financial risk in the form of loan financing or product risk in the form of selling products that could lead to the business being sued, could lead to the owner being held personally liable for the liabilities of the business.

A private company takes the form of a separate legal entity and thus limits the personal liability that its owners (shareholders) could be subjected to.

VAT

It may also be favourable for a sole proprietor to switch to a private company to enable the business to register for VAT. This arrangement could create a benefit for the company by allowing the company to claim input VAT on vatable expenses incurred.

It is, however, very important to consider the VAT status of your target market. Once a company is registered for VAT, it has to charge output VAT of 15% on any taxable supplies (sales) it makes.

While customers who are registered for VAT may in turn claim this 15% back as input VAT, non-VAT registered customers would not be allowed to claim input VAT and would practically experience an increase in your selling price of 15%.

It is mandatory for a business to register for VAT if the total value of taxable supplies made in any consecutive twelve month period exceeded or is likely to exceed R1 million.

A business may also choose to register voluntarily for VAT if the value of taxable supplies made or to be made is less than R1 million, but has exceeded R50 000 in the preceding 12 months.

Income Tax

Income earned by a sole proprietor is included in the taxable income of the individual owner of the business. This means that the business’ income is taxed, along with the owner’s other forms of income, according to the sliding scale of income tax rates applicable to individuals:

Taxable income (R)	​Rates of tax (R)
1 – 205 900	18% of taxable income
205 901 – 321 600	37 062 + 26% of taxable income above 205 900
321 601 – 445 100	67 144 + 31% of taxable income above 321 600
445 101 – 584 200	105 429 + 36% of taxable income above 445 100
584 201 – 744 800	155 505 + 39% of taxable income above 584 200
744 801 – 1 577 300	218 139 + 41% of taxable income above 744 800
1 577 301 and above	559 464 + 45% of taxable income above 1 577 300

Private companies are subject to South Africa’s corporate tax rate of 28%, irrespective of the amount of taxable income earned by the company.

From the above you can gather that, once the taxable income earned by your business exceeds approx. R660 000, it would be more tax efficient to form a company and be liable for tax at 28% of the taxable income earned.

SARS provides further relief for small business in the form of Small Business Corporations (SBC) tax. To qualify as an SBC, a company must comply with the following requirements:

1. All shareholders are natural persons.
2. All shareholders hold no shares in any other private company.
3. All members hold no members’ interest in any other Close Corporation.
4. Gross income for the year of assessment does not exceed R20 million.
5. Not more than 20% of the gross income and all the capital gains consist collectively of investment income and income rendering a personal service.

SARS applies the following sliding scale of rates to companies that qualify as SBC’s:

Taxable Income (R)	​Rate of Tax (R)
1 – 83 100	​0% of taxable income
​83 101 – 365 000	​7% of taxable income above 83 100
​365 001 – 550 000	​19 733 + 21% of taxable income above 365 000
​550 001 and above	​58 583 + 28% of the amount above 550 000

With the favourable tax rates applicable to SBC’s compared to the tax rates applicable to individuals, it would be very tax efficient to switch any business that qualifies as an SBC from a sole proprietor to a private company.