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Milking Your Cash Cow

What is the best way to extract surplus cash from your business?

Milking Your Cash Cow

You've finally reached the Promised Land of entrepreneurship: a business that is small enough to manage without too many headaches, but large enough to churn out healthy profits like clockwork. So what's the best way to extract all of that surplus cash and reward yourself for years of blood, sweat and tears?

There are three obvious options: remuneration, dividends, and shareholder loans. Many owners will be primarily concerned with their respective tax implications, which will vary depending on your particular circumstances (e.g. whether your business qualifies for the Small Business Corporation tax structure or not).

As a rough rule of thumb, increasing your salary will probably be more tax efficient than paying a dividend until you approach the highest income tax bracket (i.e. 45%). Yes, the dividends tax rate is only 20%, but they're paid from after-tax profits, so the effective tax rate can actually end up over 42%.

Increasing your remuneration has the added benefit of reducing your company's taxable income, but bear in mind that SARS can disallow salary deductions if they're deemed excessive relative to market benchmarks.

Loans are usually not a good idea. Interest-free or low-interest loans are deemed to be dividends and will be taxed accordingly. However, unlike actual dividends, they'll continue to be taxed as deemed dividends until they're repaid. Loans can also expose your personal assets to risk in the event of business creditor claims.

Tax aside, there are some other important factors to consider. Increasing your remuneration has the advantage of putting cash in your pocket immediately. Dividends, by contrast, tend to be declared at the end of the financial year, so you'll have to wait for your payout.

That said, the cash flow advantage of a salary increase can be a double-edged sword. We tend to adjust our lifestyle according to our earnings, so salary increases often get treated as disposable income instead of invested for long-term financial freedom. Dividends can just as easily be splurged on a new car or overseas holiday, but the delayed gratification fosters sobriety.

Finally, dividends don’t impact the value of your business in the same way that salaries do. As an expense, salaries reduce your profitability, whereas dividends come out of your retained earnings. If your salary goes up, then your profits and retained earnings will come down, eroding business value in the process.

Look at it from an investor’s perspective: would you rather buy a business that generates surplus earnings for its owner, or one that operates on thin profit margins due to bloated management salaries?