Mar 26

Choosing the right business Structure

The business structure you choose influences everything from day-to-day operations, to taxes, to how much of your personal assets are at risk. You should choose a business structure that gives you the right balance of legal protection and benefits.


Your business structure affects how much you pay in taxes, your ability to raise money, the amount of compliance work you need to do, and also your personal liability.

You’ll need to choose a business structure before you register your business with the government. Most businesses will also need to get a tax registration and file for the appropriate licenses and permits.

You’ll have to choose wisely because while you may be able to convert into different business structure in future, there may be restrictions based on your location. This could also result in tax consequences, among other complications.

Sole proprietorship

A sole proprietorship is easy to form and gives you complete control of your business. You’re automatically considered to be a sole proprietorship if you do business activities but don’t register as any other kind of business.

Sole proprietorships do not produce a separate business entity. This means your business assets and liabilities are not separate from your personal assets and liabilities. You can be held personally liable for the debts and obligations of the business. Sole proprietors however can still use trade names for their business. It can also be hard to raise money because you can’t sell stock, and banks are also hesitant to lend to sole proprietorships.

For taxation purpose, the income from the business or professional shall be assessed in the hands of the proprietor itself. All the exemptions and benefit available to an individual shall be available to the proprietor. Hence it is the most suitable form of business for micro and small businesses as they would be eligible for higher tax benefit.

Sole proprietorships can be a good choice for low-risk businesses and owners who want to test their business idea before forming a more formal business. It is also economical and fast to setup as no formal registration is required.

Partnership

Partnerships are the simplest structure for two or more people to own a business together. Partnerships can be a good choice for businesses with multiple owners, professional groups (like Lawyers, CA, CS), and groups who want to test their business idea before forming a more formal business.

Partnerships do not have a separate legal entity distinct from its partners. Hence the partners are personally liable for the debts and obligations of the firm even though business is carried on in the ‘firm name’. It is relevant to state that for the purpose of levy of taxes, a partnership firm is an entity quite different from the partners composing it and is assessable separately. But for all other laws, they are treated as the same.

Partnership firms in India are governed by Indian Partnership Act, 1932. Although partnership agreement can be oral, it is customary to reduce it to a written deed. Although not mandatory, firm can be registered with Registrar of firms. Registering the firm will render it a legal status enabling it to sue or be sued by others.

For the purpose of Taxation, firm will be considered as a separate person and PAN has to be taken in the name of firm. The share of profits received from the firm is exempt in the hands of the partners under section 10 of the Income Tax Act, 1961. However, any remuneration and/or interest on capital will be taxable as business income in the hands of the partners and the firm can claim deductions of remuneration and interest on capital paid to the partner under section 40(b) of the Income Tax Act, 1961.

Limited Liability Partnership (LLP)

A Limited Liability Partnership (LLP) is a partnership in which some or all partners have limited liability. It therefore exhibits elements of both partnership firms and limited companies. LLP is governed by a separate legislation called the LLP Act, 2008. However for the taxation purpose, LLP is treated in the same way as that of partnership.

An LLP is a body corporate having a legal entity distinct from its partners and has perpetual succession. Every Limited Liability Partnership must use the words “Limited Liability Partnership” or its acronym “LLP” as the last words of its name. In terms of liability, the Limited Liability Partnership is itself liable for debts running up in the business, rather than the individual partners. As a result, LLP’s are only recommended for profit running businesses. Individuals or existing businesses can be members of a Limited Liability Partnership, and the LLP must have at least two members.

Incorporating a LLP is more or less similar to that of a Limited Company. The rights and responsibilities of all members would usually be laid out in a “Partnership Deed”.  A LLP has to be incorporated with MCA and the initial agreement has to be filed within 30 days of incorporation. Any existing partnership firm or private limited/unlisted public company can also be converted into a LLP.

The Limited Liability Partnership format is an alternative form of business that provides the benefits of limited liability of a company but allows its members to retain the flexibility of internal management as in a partnership firm. This format would be quite useful for small and medium enterprises in general and for the enterprises in services sector in particular. Internationally, LLPs are the preferred vehicle of business particularly for service industry or for activities involving professionals.

Private Limited Company

Private Limited Company is the most prevalent and popular type of corporate legal entity in India. It is governed by Companies Act, 2013. A private limited company provides limited liability protection to its shareholders. It means that only the assets of the business are at risk, and not the shareholder’s personal assets such as personal bank accounts, cars and houses.

The capital of a private limited company is divided into shares which can be freely transferred in the market. A private limited company has perpetual existence and has a separate legal entity status distinct from its shareholders. Thus the ownership is separate from the day-to-day management of the company. Only the shares of a company can be sold or transferred in part or whole to another entity easily without any hassles, while the business continues as a going concern. Thus it is ideal for business which wants to grow and expand quickly and provides a tremendous edge in planning and executing a business exit plan.

To incorporate a private limited company, a minimum of two shareholders and two directors are required. A natural person can be both a director and shareholder, while a corporate legal entity can only be a shareholder. Further, foreign nationals, foreign corporate entities or NRIs are also allowed to be Directors and/or Shareholders of a Company with Foreign Direct Investment, making it the preferred choice of entity for foreign promoters. Since the information relating to the company, such as name of the company, date of incorporation, registered office address, status of the company and other information are made available in a publicly searchable database, it is easy to authenticate the existence of the business making it more credible to raise finance.

It is pertinent to note that the compliance work required under the Companies Act, 2013 is significantly complex compared to partnership firms and LLP making it less attractive for small businesses. The cost of formation and timeframe for incorporation is also high compared to other forms of businesses. It only recommended for medium and large sized businesses that are professionally managed.

Non-profit Organization

Societies, Public Trust and Section 8 Companies are the most prevalent forms of entities which render charitable and/or religious services to benefit the public at large. It is a good choice for schools, colleges, educational and medical institutions and other associations/organisations which intend to operate without a profit motive.

Societies work in a manner similar to trusts and these two terms are often used interchangeably. However, both entities are different from each other. The Societies Registration Act, 1860 governs societies in India. On the other hand, private trusts come under the purview of Indian Trust Act, 1882. Section 8 Companies are governed by Companies Act, 2013 and is registered under the MCA. Most of the resident welfare associations, co-operative milk societies and self-help units register as societies while charitable institutions and NGO register as Trust or Section 8 Companies.

Public Trust can be formed by two persons where as societies require minimum of seven members. While a Trust can be governed by a single person, Societies require a voting system to elect the governing body. A trust works as per a trust deed where as Societies have Memorandum of Association and By-laws to govern the activities. Section 8 companies can be registered and operated in the same way as a Private Limited Company but their profits can be applied only for promoting the objects of the company.  A Section 8 Company has various advantages when compared to Trust or Society like improved recognition and better legal standing. Section 8 company also has higher credibility amongst donors, Government departments and other stakeholders.

Public trusts, Societies and Section 8 Companies enjoy various tax benefits. For this they have to be registered under Section 12A of the Income Tax Act, 1961. Further the donors of the NPOs can claim deduction of their donation if the NPO is registered under Section 80G of the Income Tax Act.

DISCLAIMER: While every effort has been taken to provide correct information, the authors/ publishers will not be liable for any loss, expense, liability, detriment or deprivation suffered arising out of any action based on the information provided above. The readers are expected to cross-check the facts and information with government circulars and notification.

ByPadmanathan KV

An Associate Member of Institute of Chartered Accountant of India and a commerce graduate. Practicing in the field of Taxation and currently a partner in K.V.Venkitaraman & Co, Chartered Accountant, Palakkad. Former Secretary for Palghat branch of SICASA, ICAI (2015-2016) and has hosted numerous workshops, seminars, cultural and sports events including a National Convention for CA students. Also a Faculty for CMA Chapter for Direct and Indirect Taxation. Presented numerous papers on Direct and Indirect taxation.