Becoming self-employed means moving from the relatively simple pay-as-you-earn (PAYE) system, where tax is deducted off monthly salaries, to the more complicated provisional tax system.
This requires a whole lot of additional admin, including estimating earnings.You also need the discipline to put away enough income to cover future tax liabilities, at a time when you rather want to invest money in your business.
Provisional tax is an advance payment on expected taxable income and provisional taxpayers are expected to make estimates, in advance, of how much they expect to earn.
There are generally two provisional tax payments, one six months into the year of assessment, and one at the end of the assessment year. A third optional payment may be made after year-end if the first two have been off the mark and you want to avoid interest.
The payment calculations can be based on an actual estimate of expected income or on taxable income in the most recently assessed tax year, escalated by 8% a year if annual returns are in arrears by more than 18 months.
To avoid underestimation penalties when you submit your second return, your estimate of taxable income must be within 90% of actual taxable income (if less than R1m and if you have used a lower estimate than the previously assessed figure when making your first payment). If you earn more than R1m a year, your estimate must be within 80% of taxable income.
There are penalties for late submission and non-deductible interest is charged on late payment.
For most people running their own businesses, making these estimates is not easy as income may fluctuate or be uncertain. Often people overestimate income and then end up paying more tax than they need to, and then struggle to obtain a refund.
When focusing on building a new business, it is easy to take your eye off the ball, and tax penalties suddenly become a reality as deadlines are missed, records weren’t kept accurately, or business expectations are unrealistic.
Mike Betts, tax director in Grant Thornton’s Cape Town office, says the first decision people need to make when they leave formal employment is whether to operate as a sole proprietor or in a partnership, or to set up a company.
If you operate a company, you can pay yourself a salary and deal with remuneration on a PAYE basis. This means you may not have to register as a provisional taxpayer, but your company would still have to.
As sole proprietor, you will need to deal with provisional tax in your own name.
When starting a business, and when costs and overheads are critical to survival, you would probably not want to expose yourself to the costs of running a company until you reach a certain size, says Betts.
“Once taxable income exceeds R1.5m there may be a tax advantage in operating through a company with the effective rate of tax (including the impact of dividends tax) being 42.4%, as opposed to the maximum marginal rate of 45% which kicks in above R1.5m in the hands of natural persons.”
Certain concessions are available to companies that qualify as small business corporations. At the same time, companies do pay more capital gains tax than individuals.
When operating a business where there is little certainty or regularity in operating profit, you will have to make an estimate. “It needs to be done fairly carefully because if you get it wrong and underestimate, you can end up being penalised,” says Betts.
It is crucial to keep annual returns up to date to avoid the base from previous years being unnecessarily inflated by 8% per annum.
“When making an estimate of taxable income, it is essential that you do this as diligently and realistically as possible. If penalties are imposed for underestimation, it becomes a lot more difficult to have them remitted if you cannot demonstrate to Sars that you have applied your mind properly and thoroughly when performing the supporting calculations.
“This is particularly important when submitting a provisional tax return for the first time and when submitting the returns for the second period in each subsequent tax year.”
Betts says that you have to be able to demonstrate that any deductions claimed were expenses incurred in the production of income. Many people have unrealistic expectations about the deductions they can claim. “These expenses must be relevant to the business and must be actually incurred for the purpose of trade,” he says.
Provisional taxpayers often forget to include other sources of income in their calculations, Betts warns. “You must not only think of your business, but also the impact on your tax liability of capital gains, interest and investment income.”