Tax trap for small professional service companies
06 June 2016
Posted by: Author: Keith Engel
Author: Keith Engel (SAIT)
change in law makes professional service businesses vulnerable during a SARS
audit, often to the surprise of the businesses owners.”
Government has repeatedly
stated its professed love for small business in speeches and in the media. We even have governmental structures
dedicated to small business. In terms of
tax, our legislation includes special income tax relief for small business
companies and an alternative turnover tax regime for micro-businesses. In particular:
- Small business companies enjoy a 0, 7 or
21 per cent rate (as opposed to the normal 28 per cent rate) for net income
below certain thresholds, as well as 100 per cent upfront depreciation allowances.
- The turnover tax allows small businesses
to opt out of the income tax altogether in favour a maximum 3 per cent charge
on turnover below certain amounts.
Yet, this professed love
for small business does not extend to service operations, especially
professional services such as accounting, medical and legal. National Treasury and SARS have consistently
viewed these high-end services as outside the need for special tax relief. A case in point is the turnover tax, which
expressly excludes professional services from the relief.
No such express exclusion
exists, however, for professional services in regard to small business company
relief. The only express exclusion exists
for services performed personally by the company’s owners, where that company
does not have three or more full-time employees. Service companies of slightly larger scale receive
relief. The purpose of this very small
service exclusion does not appear to be aimed so much at professional services
in general, but only at professional services as life-style businesses (wherein
one practitioner holds him or herself out for business to the public) or for
solo practitioners that avail themselves of company status to disguise their
quasi-employee relationships as formal contractual consultancies.
lawyers, and other professional firms with three or more full-time employees are
not explicitly barred from utilising small business company relief.
Unfortunately though, it
now appears that professional service firms face a new difficulty that is arising
on audit. This difficulty arises when
the firm incorporates as a personal liability company. Unlike the typical company, the directors of
these entities are jointly and severally liable for the debts and liabilities
of the company during their periods in office.
These companies exist because professional associations often require
this waiver of limited liability as a formal or informal condition for
membership. Previously the invocation of
limited liability in terms of professional services seemed unethical because a
professional should fully stand by his or her work. Vestiges of this practice continue today.
When the small
business company regime was enacted in 2001, no legislative exclusion existed
for personal liability companies. The
problem only arose once the Companies Act was enacted in 2008. The new Companies Act altered core
definitions such as the "close corporation” and "private company” definitions. The new private company definition under the
2008 Companies Act expressly excludes personal liability companies (with these
companies never having been part of the 1984 close corporation act). The tax impact of this change in wording does
not appear to have been contemplated when the wording in the Income Tax Act was
updated in 2013 to incorporate the references to the Companies Act of 2008.
personal liability corporations now find themselves in a bind. SARS is auditing these entities for wrongfully
claiming small business company status.
Many of these companies will be caught wholly unaware because the owners
of these entities only reviewed eligibility status when entering into the
venture many years ago (with the relief being available under old company
law). This relief was assumed to
continue. The legislature updated the
reference to "private company” seemingly unaware that the term "private
company” has a very different meaning under the 2008 Companies Act versus prior
law. No explicit discussion of how this
change relates to personal liability corporations was ever raised in the
legislative history. Nonetheless, "the words are the words”, leaving these
corporations vulnerable on audit.
The question thus becomes
whether the law can be changed (going forward and back) to undo the unintended
anomaly arising from the 2008 Companies Act.
From a historical legislative perspective, there is no policy reason to
exclude personal liability companies from small business company relief. Only smaller service firms (of under three
full-time persons) are excluded – not all professional service firms (as
contrasted with the wholescale exclusion of professional services from the turnover
tax). There are also no policy reasons
for targeting professional services firms merely because they operate as a
personal liability company while providing relief for other professional
service firms operating under a different legal form. Some sympathy should also exist for firms
being caught unaware of the unintended 2008 change.
Requests for relief in
terms of personal liability corporations are likely to fall on deaf ears if the
National Treasury and SARS understand that these corporations are almost
exclusively run by professional service firms.
hostility toward these forms of services is well-known. Even the Davis Tax Committee appears to show hostility
towards high-end professional service firms in its interim report on Small and
Medium Enterprises. The report notes
with concern that certain forms of high-end services (e.g. financial services,
insurance and medical) enjoy 24 per cent of the total relief.
Given these concerns, a
real risks exists if one seeks to obtain policy relief for personal liability
corporations engaged in professional services.
Not only will the request be denied, but highlighting the issue could
result in the outright exclusion of professional services from the small
business company regime altogether.
Query whether the
hostility to professional services is justified. Technical degrees do not offer an automatic
ticket to wealth as the National Treasury, SARS and the Davis Tax Committee
seem to believe. The difference between
success and failure often has little to do with technical skill, but business
acumen. Professional service firms of a
smaller nature face many of the same risks (and provide the same economic
externalities) as other small service operations. At some point, Government needs to reconsider
its antipathy toward services, given that most small businesses come in the
form of service operations. After all, small businesses lack the capital to
engage in manufacturing and other capital-intensive operations. Let’s hope an improved dialogue relating to
small business service firms comes sooner rather than later.
This article first appeared on the May/June 2016 edition on Tax Talk.