What should you do with accumulated profits in your Israeli corporation?
As an accountant serving small company owners in Israel, I’m sometimes asked what to do with corporate profits: whether to leave them in the company to invest in assets or to take a dividend and invest as an individual.
This decision has enormous tax implications that can affect the long-term profitability of your investment. Israeli corporations are required to pay a flat 23 percent tax on their profits every year. When these profits are distributed to material shareholders (i.e. owning 10 percent or more of the company) they must pay additional 30 percent on the dividend. This tax is computed after deducting the 23 percent corporate tax. So the effective tax rate on corporate profits that are distributed to the shareholders is 46.1 percent.
One advantage of reinvesting the profits within your Israeli corporation is that you will not need to pay the 30 percent dividend tax immediately, thus allowing for a larger investment (with a larger potential profit). However, the downside of this approach is the tax rate on most types of passive income is much lower than 46.1 percent. In Israel, the tax rate on capital gains and dividends is 25 percent, the most common tax rate on rental income is 10 percent, and the tax rate on interest from bank deposits is 15 percent.
For the sake of illustration, let’s assume you have one million NIS of after-tax profits in your Israeli corporation and you want to build a stock portfolio. Furthermore, let’s assume your portfolio doubles in value after 10 years and you plan to use the money at that point. Leaving the profits in the corporation will give you an initial investment of one million NIS, which will become two million NIS after 10 years. After selling the stock and paying the combined 46.1 percent tax on corporate profits, you will be left with 1,078,000 NIS.
On the other hand, if you decide to invest as an individual, your initial investment will be 700,000 NIS and your portfolio will double to 1,400,000 NIS after 10 years. Upon sale of the stock, you will pay 25 percent and be left with 1,050,000 NIS.
In either case, the company owner may want to sell the stock in 4 yearly installments to avoid mas yasaf (an additional Israeli income tax imposed on total income in excess of 721,560 NIS per year).
The above example is only relevant to stocks which are taxed at the rate of 25 percent. Using the above example would not work for investments that are subject to much lower tax rates. In the case of investment rental real estate, you will need to factor depreciation and property management expenses and compare it to the 10 percent flat rate on gross that is imposed on individuals. In most cases, it is more tax-efficient to invest in real estate as an individual. However, there could be some exceptions if a property has a very high depreciation and you plan to sell it within 25 years.
So the bottom line is that whether to invest within the company or to do it as an individual is not a straightforward decision and it requires professional tax planning. To make things more a little more complicated, a proposed law that is currently being discussed in the Knesset will impose a 2 percent tax on undistributed corporate profits and small company owners will have the option of avoiding this tax by prepaying 5-6 percent towards their future dividend tax. As of right now, it is too early to speculate what the exact tax computation will be, but this will definitely affect the tax planning of corporate profits.
The content of this article is intended to provide general information on the subject and does not constitute legal or tax advice. You should consult with a tax professional where appropriate.