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Corporation or Sole Proprietorship? A Tax Perspective

In planning to start a business, deciding between a corporation and a sole proprietorship is one of the first considerations. The differences used to be clear-cut — corporations for large businesses, sole proprietorships for smaller ones. For the most part, that remains true.

But the recent amendment to the Corporation Code, allowing the establishment of One Person Corporations (OPCs), may blur the difference for some aspiring entrepreneurs.

Like sole proprietorships, OPCs only have one owner, but that’s one of very few similarities. OPCs are structured like a regular corporation, function as a corporation, and, more importantly for this article, taxed like a corporation.

Starting with the basics, sole proprietorships and corporations differ in their structure. Even OPCs, which can have only one stockholder, are still different from sole proprietorships in terms of structure. Corporations are distinct entities from the owner, unlike in a sole proprietorship.

For example, the corporation’s debt is not the owner’s debt, whereas in a sole proprietorship, it is.

A consequence of that type of structure is the longevity of a corporation. If the owner of a sole proprietorship passes away, the business ends whereas corporations do not. Per the recent amendments to the Corporation Code, corporations can exist forever.

Also, a corporation (but not OPCs) can be owned by multiple people, meaning it can have a significantly larger capitalization.

On to the taxability of corporations and sole proprietorships, as earlier noted, there are significant differences. Corporations are subject to the corporate income tax (CIT), while for sole proprietorships, the personal income tax (PIT) under the graduated income tax table applies.

Taking a glance at the graduated income tax table, you might think that once your taxable income goes over P800,000, the sole proprietorship’s tax due would be as high as a corporation’s. After all, the rates would be the same at 30%.

But that’s easily found wrong. Once you exceed P800,000, the tax under the graduated income tax will be P130,000 + 30% of the excess over P800,000.

Note, of the excess.

Even at a taxable income of P5 million, the tax due under the graduated income tax table is lower. The P5 million would be subject to P490,000 + 32% of the excess over P2 million. This translates to a tax due of P1,450,000. On the other hand, the CIT would have been P1,500,000 (30% of P5 million).

Very little difference, at that point, but still a difference. Under the current tax regime, the CIT and PIT dues will be equivalent at the taxable income of P7,500,000. Under both, the tax due would be P2,250,000.

This means if a business has more than P7,500,000 in taxable income, it will be paying less tax as a corporation than as a sole proprietorship. (See Table 1)

Corporation or Sole Proprietorship? A Tax Perspective, Table 1

But that doesn’t mean you shouldn’t register as a corporation if you have a lower taxable income than that. There are still other benefits to consider.

Besides, with the ongoing Comprehensive Tax Reform Program (CTRP), the tax rates may also change.

Under the TRAIN Law (Tax Reform for Acceleration and Inclusion or Republic Act No. 10963), the PIT will be lowered further in 2023. In addition, should the second package of CTRP (also known as the Tax Reform for Acceleration and Inclusion or TRABAHO bill) pass, the CIT would also be lower by then.

By 2023, (assuming the current version of TRABAHO passes), the CIT would be lower than the PIT at a taxable income of P5,000,000. By 2029, the CIT would be 20%, which means for as low as a P2,000,000 taxable income, corporations will be paying a lower tax than sole proprietorships. (See Table 2)

Corporation or Sole Proprietorship? A Tax Perspective, Table 2

But one crucial thing to remember is that the earnings of the corporation is not the business owner’s. On paper, the business owner might think that they saved on taxes. In truth, they would still have to pay more taxes to actually transfer that money to their pockets.

There are a variety of ways to do so — cash dividends, director’s fees, or salary. For sole proprietorships, this is not the case. Whatever the sole proprietorship earns, the business owner earns as well.

In the end, what the corporation offers from a tax perspective is flexibility. As an individual or a sole proprietor, the income, regardless of where it came from, is lumped together and taxed as a whole. As a corporation, the business owner might opt to collect a certain portion only as their salary, fee, or dividend, and use the remaining earnings of the corporation to grow the business.

This flexibility when it comes to taxes allows taxpayers to implement tax saving schemes that can benefit them.

Another way of saving more on taxes is the avoidance of unnecessary compromises and penalties. To avoid these penalties, taxpayers must ensure that they are perfectly compliant.

Through its flagship Citizen Tax Planning program, the Asian Consulting Group does just that. Since the start of its operations, the firm has helped its partners save millions on taxes. For more inquiries, contact us at [email protected] or (02) 622-7720.

This article was originally published in BusinessWorld.

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