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Pros & Cons for Changing Your Small Business to a Private Limited Company (Sdn Bhd)

We have put together calculated scenarios for you to better understand what pros & cons there is for incorporating a Private Limited Company instead of a small business enterprise
small business to private limited company sdn bhd, save personal income tax

Question:
Hi, I’m Chong. I work as a project engineer for a local construction company. My monthly salary is RM 10,000 and I had received a one-month bonus in early this year.

Also, I co-own Glow, an online fashion store with Stephy, my girlfriend. Stephy is the main partner and runs Glow full-time. She owns 70% interest in our small business while I own its remaining 30% stake. Glow has reported RM 150,000 in earnings last year and is projecting to earn RM 200,000 this year.

My question is: ‘Should Stephy and I incorporate our small business (a partnership) into Glow Sdn Bhd (a private limited company) to save on income tax income tax payments?’
Answer:
Here, I’ll share four main factors to consider before deciding on whether or not, Chong and Stephy should incorporate their small business partnership into a private limited company (Sdn Bhd). They include:

1. Additional Compliance Costs with Private Limited Company

In general, Chong and Stephy may incur at least RM 5,000 per year in additional compliance cost to administer a Private Limited Company (Sdn Bhd). They include audit fees, tax filing, and secretarial fees respectively. Different accounting firms may offer these services at slight variation to the above figure. For the sake of our discussion, I’ll use RM 5,000 as a benchmark to the amount of compliance costs for Private Limited Company (Sdn Bhd).

2. Personal Reliefs

The amount of personal reliefs claimable would greatly influence the maximum tax bracket for Chong and Stephy. They can lower their maximum tax brackets if they are able to claim more personal reliefs. Here, let’s assume both Chong and Stephy’s personal reliefs for year assessment (YA) 2019 are as follows:

If Glow is a Partnership Entity:

Under a partnership, Stephy is not required to contribute EPF as she can opt to not draw a salary from her small business. If she does not have a life insurance policy currently, Stephy’s tax relief claimable under ‘EPF and Life Insurance Premiums’ would be zero.

Tax Reliefs Chong (RM) Stephy (RM)
Personal Reliefs 9 000 9 000
Parental Care
(Both Chong & Stephy’s Parents are above 60 and have retired)
3 000 3 000
Medical Insurance Premiums 1 000 1 000
EPF and Life Insurance Premiums 7 000 0
Total Tax Reliefs 20 000 13 000

If Glow Sdn Bhd is to be Incorporated:

It may be wiser for Stephy to draw herself a fixed salary, let’s say, RM 7,500 per month or RM 90,000 a year. Stephy’s share of EPF contribution would work out to be RM 9,900 (employee’s portion). The amount of personal relief Stephy can claim is capped at RM 7,000 per year starting in YA 2019. Thus,

Tax Reliefs Chong (RM) Stephy (RM)
Personal Reliefs 9 000 9 000
Parental Care
(Both Chong & Stephy’s Parents are above 60 and have retired)
3 000 3 000
Medical Insurance Premiums 1 000 1 000
EPF and Life Insurance Premiums 7 000 7 000
Total Tax Reliefs 20 000 20 000

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3. Estimated Tax Savings

I’ll offer two sets of calculation for Chong and Stephy’s income tax payments to illustrate tax saving possibilities if they opt to incorporate Glow Sdn Bhd.

If Glow is a Partnership Entity:

Collectively, Chong and Stephy would pay RM 45,080 in income taxes from their combined income of RM 330,000. Their combined effective tax rate is 13.66%.

Formula:
= (Total Income Tax Payments + Compliance Costs) / Total Income x 100%
= (RM 27,700 + RM 17,380) / RM 330,000 x 100%
= 13.66%

Tax Payer Chong (RM) Stephy (RM)
Section 4(a) Business Income
Chong: 30% stake of Glow’s Earnings of RM 200 000
Stephy: 70% stake of Glow’s Earnings of RM 200 000
60 000 140 000
Section 4(b) Employment Income
Chong: Annual Salary: RM 120 000
Chong: One Month Bonus: RM 10 000
130 000 0
Total Income 190 000 140 000
Less: Personal Relief (20 000) (13 000)
Chargeable Income 170 000 127 000
Individual’s Income Tax Payable
First RM 100 000 @ RM 10 900
On the Next RM 150 000 @ 24%
27 700 17 380

If Glow Sdn Bhd is to be Incorporated:

Glow Sdn Bhd is a separate entity from Chong and Stephy and thus, will pay tax separately. Let’s assume that its paid up capital is lower than RM 2.5 million. Its earnings will be charged at a flat rate of 17% for its chargeable income is below RM 500,000. Hence, Chong and Stephy can retain some of Glow’s profits within the company where they would be subjected to 17% in corporate tax instead of 21-28% in maximum tax bracket when assessed as an individual’s income.

Collectively, the total amount of income tax payments by Glow Sdn Bhd, Chong and Stephy are RM 36,600. They would spend RM 5,000 in compliance costs for the administration of changing their small business to a private limited company. Their total payment is RM 41,600, which is RM 4,020 lower than RM 45,080 payable if they opt to maintain the business as a partnership. The proportion of their payment to total income is 12.61%.

Formula:
= (Total Income Tax Payments + Compliance Costs) / Total Income x 100%
= (RM 18,700 + RM 13,300 + RM 4,600 + RM 5,000) / RM 330,000 x 100%
= 12.61%

Tax Payer Glow Sdn Bhd (RM) Chong (RM) Stephy (RM)
Section 4(a) Business Income
Chong: 30% stake of Glow’s Earnings of RM 200 000
Stephy: 70% stake of Glow’s Earnings of RM 200 000
n/a n/a n/a
Section 4(b) Employment Income
Chong: Annual Salary: RM 120 000
Chong: One Month Bonus: RM 10 000
Stephy: Annual Salary: RM 90 000
n/a 130 000 90 000
Corporate Profits 110 000 n/a n/a
Total Income 110 000 130 000 90 000
Less: Personal Relief n/a (20 000) (20 000)
Chargeable Income 110 000 110 000 70 000
Income Tax Payable
Chong: First RM 100 000 @ RM 10 900
Chong: On the Next RM 150 000 @ 24%
Stephy: First RM 70 000 @ RM 4 600
18 700
(Flat Rate: 17%)
13 300 4 600

4. Borrowing Capacity

Although Chong and Stephy are able to save on income tax payments by having their small business incorporated to a Private Limited Company (Sdn Bhd), there is one key benefit that they could be losing out by doing so. It is related to their personal borrowing capacity. Low income tax payments reflect low income earning capabilities and thus, lowering one’s loan eligibility. It can be detrimental to both of them if they wish to invest in properties in the immediate future to build long-term wealth.

For instance, Chong and Stephy’s loan eligibility are estimated as follows:

If Glow is a Partnership Entity:

Let’s assume both Chong and Stephy have no outstanding debt of any kind and are below 35 years old, they have combined maximum loan eligibility of RM 3.3 million.

Tax Payer Chong (RM) Stephy (RM)
Annual Total Income 190 000 140 000
Monthly Income 15 833 11 667
Maximum Allowable Debt Commitments a Month
(based on maximum debt-service ratio of 60%)
9 500 7 000
Loan Eligibility
(based on Rule of 200)
1 900 000 1 400 000

If Glow Sdn Bhd is to be Incorporated:

Chong and Stephy will report lower income to the Inland Revenue Board (IRB). Instead of RM 3.3 million, their combined loan eligibility amount would reduce to a maximum of RM 2.2 million. Definitely, it is a far cry from having RM 4,020 in savings after incorporating Glow Sdn Bhd.

Tax Payer Chong (RM) Stephy (RM)
Annual Total Income 130 000 90 000
Monthly Income 10 833 7 500
Maximum Allowable Debt Commitments a Month
(based on maximum debt-service ratio of 60%)
6 500 4 500
Loan Eligibility
(based on Rule of 200)
1 300 000 900 000

But, don’t an Sdn Bhd have the capacity to own properties and apply for loans?

The answers are yes to both questions. But, Glow Sdn Bhd is a new company. It needs to build a financial track record of 3 years before it can apply for loans. It is able to obtain a mortgage of up to 60% in loan-to-value (LTV) as compared to 70% LTV for an individual mortgage who is buying his third property or more.

Hence, it may not be a wise move for Chong and Stephy to incorporate a Private Limited Company (Sdn Bhd) if they wish to buy properties under their personal capacity.

Conclusion:

Incorporating your small business into a Private Limited Company (Sdn Bhd) is a good idea if you wish to enjoy tax savings (especially for you if you earn RM 200,000 and above), do not intend to buy properties under your personal capacity, or intend to buy properties under a Private Limited Company (Sdn Bhd) in 3 years from today.

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