An entrepreneur, when starting a business has two options for his legal status – sole proprietorship or single member company. This article explores the choices available to entrepreneur from the point of view of Income Tax Law.
Every provision contained in part IV of chapter III – Income from Business – is applicable to both legal forms except one provision and that is salary. Since business is a separate entity from the owner for the purpose of accounting, therefore, salary received by the owner/manager from the business is viewed differently by Income Tax Law.
Understanding of the issue of salary received by the owner/manager is critical to decide about the legal form of the business.
Section 2(20) defines “employee” means any individual engaged in employment;
Section 2(22)(a) defines “employment” includes a directorship or any other office involved in the management of a company;
Section 12(2) defines “salary” means any amount received by an employee from any employment,
From the reading of the above three provisions of the law, it is clear that amount received by the owner/manager from his business is salary expense when he is a director of the company otherwise the amount is not treated as salary and hence is not an expense. Owner/manager shall be treated as director only in a limited company.
The second difference is the necessity of annual audit of accounts in case of limited company under rule 34(4)( e ) of Income Tax Rules.
The third difference is the effective rate of tax. Clause 1 of Division I of Part I of The First Schedule to Income Tax Ordinance provides rates of tax for income from business of sole proprietorship. The scheme of rates is slab based, different rates at different levels, however, maximum rate of tax is 25% applicable on income exceeding Rs. 1.5 (Million). Clause 1A of Division I of Part I of The First Schedule to Income Tax Ordinance provides rates of tax for salary income. Division II of Part I of The First Schedule to Income Tax Ordinance provides rates of tax for income from business of companies. In case of small companies as defined in section 2(59A) flat rate is 25% and for other companies the flat rate is 35%.
So the choice is very heavily tilted towards the effective rate of tax, which should be calculated keeping all the three differences in mind.