How to move your small business into a company tax-free

2020 has been a difficult year for many and it isn’t getting any easier. People have lost their jobs and, with the latest lockdown, more are likely to. But perhaps one of the better traits of the human race is its ability to adapt and to be innovative, especially in times of difficulty. So, we have also seen new businesses springing up everywhere “(like phoenixes from the ashes).

From small catering businesses that deliver food to people’s homes and travelling car washes to on-line yoga or work-out businesses…..the list is endless. Whilst many of these businesses will hobble along or fail completely in the long term, some have grown quite quickly (and sometimes unexpectedly) such that their turnover is much higher than the person who started them imagined and they are having to employ people to help. Since they started off small the businesses were conducted in the person’s own name, but now it is becoming clear that this is not a sustainable situation and the need to separate the business from ‘self’ by putting it in a company is necessary.

Why? As the business grows it will become exposed to liabilities and risks that were not there when you operated it as a ‘one-man-show’. You want to separate these out and put them in an entity where they will be ring-fenced. Liabilities won’t necessarily only be in the form of loans from a bank but may arise because you are having to pay creditors and employees. There may also be product liability type risks. In addition, you may have been operating the business using your own bank account, but now you need to open a business account so that the financial line between yourself and the business is clear.

But how do you do move the business that you have created into a company without paying taxes? If you are to own more than 20% of the shares in the new South African company (- let’s call it MyCo), the transfer of e.g. fixed assets and stock assets would, ordinarily, be deemed to take place at market value, potentially resulting in income tax, including capital gains tax (CGT) becoming payable.

For a change, the tax legislation comes to the rescue in this scenario. If any of the assets to be transferred are worth the same or more than when you bought them (i.e. market value is equal to or greater than base cost) section 42 of the South African Income Tax Act allows you to transfer that asset in return for shares issued by MyCo, with no income tax or CGT. Basically, the ‘base cost’ or tax value (value after capital allowances) of the asset is transferred and the shares issued to you by MyCo will have the same ‘base cost’ or tax value. This means that you will only pay tax when you actually sell the assets or shares to someone else.

The catch? There are always one or two, but here they are outweighed by the benefits:

• The accounting or agreement transaction must be at full market value (in order not to trigger dividends tax or CGT when MyCo issues the shares to buy the assets, or donations tax), even though the tax position is that they are transferred at base cost/tax value;
• You must hold at least 10% of the shares and voting rights in MyCo on the same day as the assets are transferred (and hold onto them for at least 18 months) OR you must undertake to work in MyCo for at least the next 18 months and do so;

Where all the assets of the business are transferred there will be no VAT. Securities transfer tax (STT) (if the assets are shares) and transfer duty on any properties transferred to MyCo also won’t apply for the assets that are transferred under the section 42 rules.

This tax-free transfer from you to MyCo is automatic, provided the requirements are fulfilled and you don’t ‘opt out’ in writing.

It’s basically that simple.

By way of example, let’s say your business now has some industrial type machinery that you bought at an auction for R80 000 in May 2020 (you could sell it now for R100 000), you bought your trading stock on hand for R45 000 (you could sell it now for R60 000 as you have made some finished product) and you have debtors that still owe you for sales amounting to R40 000 (all collectible). You can form MyCo with, say, 200 shares. You sell the machinery, trading stock and debtors, as a going concern, to the company in return for the 200 shares i.e R200 000 (R1 share for every R1 000 of value).  

For tax purposes, however, the machinery, trading stock and debtors will transfer to MyCo for their base costs or tax values  i.e. in the example, R80 000, R45 000 and R40 000, respectively, i.e. no taxable capital gains or profits for you on the sale, despite the current market values. MyCo will take on these same amounts and treat the assets, for tax purposes, exactly as you would have in your own hands. The 200 MyCo shares, which you will now hold as capital assets, will have a base cost equal to the total base cost/tax values transferred i.e. R165 000 in the example.

If a tax year had passed and you had claimed, say, 40% of the cost of the machinery as a depreciation allowance in that tax year, so that its tax value is now R48 000, you would still have no tax and the tax value passed to MyCo for the machinery would then be R48 000. MyCo would then claim the next allowance in its next tax year. The shares issued to you by MyCo would have a base cost of R133 000 in this scenario (R48 000+R45 000 + R40 000).  

However, even though the section 42 rules are automatic, I would recommend you to make use of an accountant and/or lawyer just to make sure all the paperwork is in order, that all the section 42 requirements are satisfied and to assist you to make sure that the recording of the assets for accounting and tax purposes is done correctly. You will need their help to form the company, anyway.

But what happens of the not all the assets have a market value equal to or greater than their base cost? Since section 42 applies on an asset-by-asset basis the non-qualifying assets can be transferred at their actual value (there will be no income tax or CGT to pay as they are worth less than their base cost or tax value, anyway). You will just need to make sure the VAT, STT or transfer duty is handled correctly.

The next thing to determine is whether MyCo will qualify for the “small business” tax rates (lower than 28% for taxable income of up to R550 000 (2021 tax year)), but that’s a whole other article.