Which Legal Structure is Right for Your Startup?

If you are confused in deciding which legal structure is right for your startup, you can perform a quick test. This post helps you understand legal structures and their income tax liability. But remember, income tax liability is not the only perspective. I wrote another post about withholding taxes in Pakistan and their impact on legal structure of a startup. That post is also a must read.

Let’s say you and one of your friends own a business. Annual net income (profit before tax) of the business is Rs. 10 million. Let’s assume it a small company. I have made all calculations in this post considering tax rates for Tax Year 2020.

For simplification, I have assumed that each partner wants to take out Rs. 3 million from business. We will see how much tax the owners will pay if (a) startup is a company (b) startup is a partnership firm.

Partnership Firm

If you register a partnership firm, annual income tax will be Rs. 2,620,000. Partnership firm will pay this tax.

This income will be exempt from tax in the hands of partners. This means partners will not pay any tax when they declare Rs. 3 million in income tax return.

Please note that salary of partners is treated as drawings. That is the reason the firm will not deduct tax from their salaries.

So, total tax will be Rs. 2,62,000 in this case.

Company

If startup is a company, directors can take money out of business in two ways.

One is in the form of salary, and the other is profit distribution.

Company with Salary and Dividend

Let’s assume another scenario. Each partner takes Rs. 1.5 million as salary and other Rs. 1.5 million as dividend.

In this scenario net income of the company will reduce from Rs. 10 million to Rs. 7 million.

The company will pay tax of Rs. 1,610,000. Each partner will pay tax of Rs. 60,000 on their salary. Partners will also pay tax at 15% amounting to Rs. 225,000 on dividend.

So, the total tax will be Rs. 2,180,000 in this case.

Company with Salary Only

If each partner takes Rs. 3 million as salary, he will pay tax of Rs. 282,500 on salary.

How much tax, the company will pay???

The net income (before tax) of company will reduce from Rs. 10 million to Rs. 4 million (Rs. 10 million less Rs. 6 million salary). The company will pay tax at 23% amounting to Rs. 920,000.

So the total tax will be Rs. 1,485,000 in this case.

There can be other scenarios as well, but I have tried to cover the important ones to give an idea of how taxation works in different forms.

Conclusion

If you form a limited liability company and take market competitive salaries as directors, total tax liability of company and directors will be minimum. So which legal structure is right for your startup from income tax liability perspective? Of course, a limited liability company.