Choosing the Right Business Structure
For entrepreneur, one of the most important decisions when starting a business is to choose the type of business entity or structure. A business entity or structure is the form and legal status of the business. A right business structure will avert problems and minimise spending in the course of the business. If one dives deep into every factor, it is not always a straightforward choice. One has to consider the type of business, the relationship and arrangement between the owners and investors, the size of the business, organization structure, assignment of duty, ease of control, accountability and transparency, business profit, the need for further investment, taxation, costs and etc.
We will provide a brief explanation of the different business vehicles and hopefully it will help you to decide which one is for your business.
There are three forms of business vehicle or entity which are commonly known by the public:
- Sole proprietorship
- Private company
Enterprise: Sole Proprietorship vs Partnership
Sole proprietorship and partnership are a form of registered business. Sole proprietor is owned and managed by one person, while a partnership is owned by two or more persons.
For sole proprietorship, there is no governing act or statute as there is really nothing to regulate in one-man show business. In contrast, partnership requires regulations in order to define the relationship between the partners and the liabilities of the respective partners. Partnership is governed by Partnership Act 1961.
Sole proprietorship and partnership are commonly categorized as an enterprise for convenience and easy understanding. Enterprise connotes a registered for-profit business that is distinct from corporation, society and other registered bodies. It has no separate legal personality. The sole proprietor and the partners will incur personal liabilities even if the name of the enterprise is being sued and not their personal names.
In Malaysia, enterprise is colloquially referred to as “trading”. A fair number of people will not understand if you state enterprise or partnership to them. There is a general misconception that those terms are about the different type of business.
Separate Legal Personality: Company
A company is an entity incorporated under the Company Act 2016 that has a separate legal personality.
Most of the people are aware that a company has the capacity to hold and own property. Besides that, it can sue and be sued and enter into transactions and contract in the same way as a natural person. This capacity derives from an artificial legal personality separate from the shareholders or members of the company.
To put it another way, a company is like an artificial person that is utilized to conduct business which shields its shareholders or those controlling it from personal liabilities. This separate legal personality capacity is acquired through incorporation under the Company Act 2016. Incorporation is a word to describe the process of which a company is constituted pursuant to the Act.
Comparison between enterprise and private company:
|Governing statute||None for sole proprietorship. Partnership Act 1961 for partnership.||Companies Act 2016/ Companies Act 1965|
|Incorporation /Registration||Register under Registration of Business Act 1956||Incorporate under Companies Act|
|Startup Costs||Registration fees of RM 30 or 60 per year. Legal fees for partnership agreement (optional).||Incorporation fees of RM 1,000. Secretarial fees. Total approximately RM 2000 and above.|
|Number of Shareholders/ Partners||1 to 20 (except partnership of certain professional practices)||1 to 50|
|Capital Contribution||Own contribution||Share capital|
|Ownership||Sole Proprietor or Partners||Shareholders|
|Management||Sole Proprietor or Partners||Boards of Directors|
|Legal Personality||No separate legal personality||Artificial and separate legal entity|
|Capacity/Power||No capacity to hold land or be a tenant.||Unlimited capacity of a natural person of full age and power to hold land.|
|Duration of Existence||No perpetual succession. Dissolved either by death or bankruptcy of any partner, unless otherwise agreed.||Perpetual succession Ownership is transferable or sold to third party.|
|Liability for Debts||Partners are jointly and severally liable for debts||Shareholders are only liable to the unpaid contributions he or she undertook to contribute|
|Company Constitution||Not required||Optional, but generally adopted.|
|Statutory Requirements to Audit Accounts||Not required to audit accounts or lodge with CCM. However, partners are required to render accounts to another partners.||Generally required to audit accounts and lodge audited accounts with SSM Audit exemption are given under Practice directive 3/2007 to private companies which are dormant, zero revenue or threshold-qualified companies, subject to certain criteria and conditions|
|Company Secretary||Not required||A minimum of one company secretary|
|Annual running costs||Lower||Approximately RM 2000-3000 and above|
|Taxation||Personal income tax||Corporate tax rate|
Limited Liability Partnership (LLP)
There is another form of a business structure called limited liability partnership under the Limited Liability Partnerships Act 2012 which we have not covered in the above table. It is a hybrid of conventional partnership and company. It has a separate legal personality, perpetual succession, ability to hold property, and can be sued and sue; it basically has the capacities and the goods of a company minus the cumbersome regulatory and compliance responsibilities imposed on a company, such as lodgment of annual return and account auditing. However, a LLP is required to file an annual declaration to declare its ability to meet its financial obligations, something like an oath by the partners.
With LLP, the business can be run in the same way as a conventional partnership, which means there are no intricacies of running a private company. Another benefit is that the business owners will not incur personal liabilities.
Unless you have a very unique business or arrangement that makes it logical to use LLP, this form of business structure is generally not suitable for starting a business. Firstly, it is because of the confusion it might create. Not everyone is familiar with LLP and its characteristics. Secondly, it will discourage anyone to do business with you because of two things (1) you can escape personal liability and (2) your business account is not transparent to the public as there is no auditing of the account for the purpose of filing annual return. Outsiders have no means to inquire into your LLP’s affair with a company search at SSM. All that being said, anyone is at liberty to disagree with our view.
Choosing between Enterprise and Company
Every time when we start a business, overhead cost is an unavoidable issue of concern. The cost of running a Sdn. Bhd. is quite heavy as you need to hire an accountant, auditor and company secretary to perform works for regulatory compliance purpose. The annual running costs can easily go up to tens of thousands every year or even more. At the very minimum, you are looking at RM 2,000 – RM 3,000 per annum just to maintain a dormant company.
The costs of maintaining an enterprise is very low. There is no requirement for the company account to be audited by a certified auditor, tabling the audited report at a director’s meeting and filing it at the SSM. Probably the only required thing is to submit a personal income tax return at the LHDN.
Tax is another important consideration in choosing between enterprise and company. Currently, a company that has a paid-up capital of ordinary shares of RM 2.5 million or less that is defined as SME will be entitled to a special corporate tax rate of 17% (year 2019) for the first RM 500,000.00 chargeable income. The subsequent chargeable income will be subject to income tax rate at the prevailing tax rate of 24%. Note that all corporate tax is charged on a flat rate basis.
An enterprise is taxed by way of personal income tax. Tax is charged on an incremental amount of chargeable income at scaled rates of 1% to 28% (year 2019). If the business will only have a chargeable income of less than RM 190,000.00 for the first year, enterprise is probably the better choice as it will only be subject to an effective personal income tax of less than 17%, which is lesser than RM 32,500.00 (effective tax rate is obtained based on our own simple calculation). If the business is expected to make more than RM 190,000.00 per year, company is probably the better choice as it will only be charged with 17% of flat corporate tax rate. This is because, after the threshold of RM 190,000.00, the effective personal income tax rate will be higher than 17%.
An alternative view is instead of using the effective personal income tax rate to determine the threshold point, the original scaled income tax rate should be used to determine. For example, if the chargeable income is more than RM 70,000.00, a company will be the better choice as any figure more than RM 70,000.00 will be taxed at 21% to 28%.
The above is only true for the first chargeable income of RM 500,000.00, since all chargeable income above the first RM 500,000.00 will be subject to a flat corporate tax rate of 24%, which means the threshold point has to be re-calculated if the chargeable income exceeds RM 500,000.00 (since there are two flat rates of 17% and 24%). It takes some time to calculate and we are not going to attempt it. Generally, people will form a company for a business with a chargeable income of more than RM 1,000,000.00. In that case, it will definitely save a lot of tax money compared to personal income tax. We are trespassing into the realm of tax planning now so we are going to stop here.
Moving on, the separate legal personality that will shield owners from personal liabilities is not really that important at the start of a business which does not involve substantial money and high risk. Some entrepreneur treats this shield against personal liability as an indispensable feature. But if your business is not big enough, it will not make any economic sense to form a company just to enjoy having that shield.
If the business is expected to require further investment from investors, a company structure will be more suitable mainly because a company can be invested in many ways such as preferential shares or through an investment scheme. An investor can invest in a partnership, but he or she will have to rely on an agreement.
Finally, it is necessary to consider the organisational structure, corporate governance and management of the business. Generally, partners are on equal footing unless otherwise agreed. It is different for a company as there are shareholders and directors. Directors will handle the day to day management of the company where shareholders generally cannot interfere. A company requires knowledge, expertise and skills to manage, and if the executive directors do not possess these qualities they must seek professional for advice and assistance. It is very common for a company to be negligently managed and directors are fined and criminally charged for violating the Company Acts 2016.
You can actually convert your enterprise into a private company when business grew big. It is possible for the company secretary to change the company name in a conversion. Typically, people would want to remove the “Enterprise” or “Trading” from the company name.
The Black and White
For every partnership and company business structure, it is advisable to have a partnership agreement or shareholder agreement in place prior to starting business. Having a solid agreement will help prevent and solve potential disputes between the business owners and save substantial litigation costs. Unfortunately, many people do not realise its importance until it is too late. Business aside, with an agreement in place you will have no problem of sleeping and you will sleep well at night. Without it, be prepared for many sleepless nights when problems arise.
At here, we do provide service of drafting commercial agreements at a very affordable rate. If you are interested to know more, you may contact us for a quotation.
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