As a freelancer should you form a company or remain a sole proprietor?
During periods of weaker economic growth, companies are more open to using freelancers or contractors to reduce their cost-to-company spend. It also creates employment in an economic environment where employers are less likely to hire fulltime staff as it allows them to be more flexible in terms of employing the skills they need when they need them. Freelancers, in turn, have the flexibility to adapt their work hours to suit their lifestyles.
Whether you are a freelancer by choice or necessity, understanding your tax obligations is important. Far too many freelancers land up in financial difficulty as they have not made provision for their tax.
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Lesedi Seforo, Project Manager: Tax at the South African Institute for Chartered Accountants (SAICA) offers some advice as to the best tax practices for freelancers.
Form a company or instead register as a sole proprietor?
Seforo says the decision as to what legal form you should use should not only be determined by tax, but also other commercial concerns such as limitations of personal liability. In the case of a sole proprietor, you are the legal entity; in the case of a company, the company would be the legal entity and would hold the liability.
From a tax perspective however, it may not make sense for a one-person consultancy to register as a company unless the company has at least three employees. Seforo says the main consideration as far as income tax is concerned has to do with the rate of tax levied on a company versus a sole trader.
Most freelancers use the fees they charge as their income and do not necessarily reinvest in the business, as the nature of their business does not require capital. In this case, Seforo says the tax effect is neutral as no income tax will be paid in the company on this amount as the full salary would be a tax deduction.
The scenario is different if the individual wishes to reinvest some money back into the business. For example, a consultant registered as a sole proprietor earning R1 500 000 profit that he or she wants to reinvest in the business, will pay about R520 000 in income tax. If the owner-manager formed a company and kept the money in the company, the company would pay a lower company tax rate of 28% – so about R420 000 income tax is payable.
You also need to take into consideration special anti-avoidance provisions that apply to companies that have only a single person rendering services. Seforo says in such instance this will limit the tax deductions the company can claim, making such type of small company unviable.
“It is therefore, from a tax perspective, usually less favourable to have a company where a consultant as owner-manager is solely rendering services and usually advisable to wait until the business has three or more unconnected employees to fall outside this anti-avoidance provision, before using a company as a business form,” says Seforo. Only when a company has several employees will it be able to access the more favourable small business tax rates, as personal services are excluded unless it meets the threshold of three or more employees.
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Moreover, the payment of VAT is more favourable for a sole proprietor than a company as a company has to pay VAT on an invoice basis while a sole proprietor works on a payment basis.
The standard rule is that VAT vendors are subject to VAT on the invoice basis, which basically means that they must pay VAT to SARS based on invoices issued during a particular period, even if those invoices have not yet been paid by the client. This can be a risk to a freelancer who has formed a company as the longer a client takes to pay the freelancer, the more likely it is that the freelancer will experience cashflow problems, as they have to pay VAT to SARS even though clients may not have paid them yet.
The alternative is the payments basis, where VAT is payable to SARS only once payments have been received from clients. This is available to sole traders who make less than R2.5 million per year, but is not accessible to freelancers trading through companies.
When should you apply for a Tax Directive?
As a freelancer or consultant, you can apply for a tax directive so that you are not paying more income tax during the year than on your final tax determination. In other words, this will equal out your monthly tax payments so that you are not overpaying tax only to receive a large rebate at the end of the year. This is usually a result of variable income payments such as commission or project payments.
You can apply for a tax directive if you are not deemed to be fully independent. If you get more than 80% of your work from one client, work at the client’s premises or under their supervision, and have fewer than three full-time employees, you would be classified as a personal service provider and PAYE would have to be deducted. If you earn commission or a variable fee, then you can apply for a tax directive where your client/employer will be instructed by SARS to deduct a specific rate or amount of PAYE. If you are not deemed an employee, as no client makes up 80% of your income and you are not under their supervision, then no PAYE would be deducted and you would pay tax in your bi-annual provisional tax return.
In this case it is extremely important to make sure that at the end of each month you put your estimated tax away in a savings account so that the provisional tax bill does not come as a shock.
What are legitimate expense claims?
For a home office, one must remember that the office must be specifically used and fitted strictly to be used as such. “A person cannot work in their living room or from a desk in their bedroom and claim office expenses from SARS,” says Seforo who explains that for a legitimate home office, most of the household expenses can be claimed from SARS, but only the portion that relates to the home office.
This apportionment can be done on a square metre basis (ie, you divide your office square metres by the total home square metres and multiply that by legitimate house expense claims). Examples of legitimate expense claims would be rent (if renting), interest on your bond (if you own the property), electricity, levies, water, other municipal charges, domestic worker etc. You would also be able to fully claim any expenses incurred due to repairs or improvements specifically to the home office area.
Amounts spent at coffee shops etc. would have to meet the tax requirements which include that these expenses are in the production of your income and in the course of your trade and not for your personal maintenance. Generally, such expenses incurred during client engagements qualify under such requirements.
Do you have to fill in a logbook?
Keeping a logbook is very important for a freelancer as they do not receive a travel allowance from an employer. In the past, you could work with deemed kilometres, but now you have to keep a logbook of all business-related travel in order to claim petrol and car maintenance expenses.
This article first appeared in City Press.