This piece is part of the series intended for business leaders, providing them working knowledge of various business laws. By its very nature, it is neither comprehensive nor is it supposed to replace the guidance of a law expert. Read more about this series.
When you think about starting a business, you think about the product/service you’d sell, who your customers would be, what you will charge, how you will market your product and many other things. Few people think of the legal structure within which the business will be run. Most simply assume they will set up a private limited company. But that isn’t the only option, and it is certainly not always the best one. Other options include a proprietorship, a partnership, a limited liability partnership (LLP), a limited liability company, a trust, or an Association of Persons etc. Again, most first-time businessmen do not know the difference between all the above-mentioned structures, much less about their legal attributes and financial and tax implications. This is understandable but ought to be remedied. Quite a few people talk of setting up an SPV (Special Purpose Vehicle), without knowing that there is no such class or type of entity. A Special Purpose Vehicle (SPV) could be any of the above formats but with a limited defined object or purpose.
So how does one decide which legal format to adopt? There are several considerations.
- Size of the business expected in initial couple of years. Smaller business should start as Proprietorship. It has all the good attributes – practically no cost of formation, minimum compliance cost on day to day basis, simpler tax laws, highest flexibility in financial dealings, confidentiality of business secrets, minimal reporting to authorities. Note that you should avoid buying immoveable property for business when it is still in Proprietorship mode. When your business grows, you may need to change the format to bigger one (such as an LLP or a limited liability company), and the transfer of property to the new entity may have tax implications. Otherwise, as of now this is the best format for starting a new business.
- Involvement of other people in ownership and operation of business in question. If others are involved, your choice gets limited to Partnerships, LLPs, and companies. In some cases, even Association of Persons may be feasible, and sometime necessary (where more than 20 people are involved).
- Risk profile of the business and the capacity of the owner to take risk. If business risk is high and beyond the capacity of the promoter of the business, it is desirable to go in for Limited Liability Company. If you do not propose to raise capital from public, it is always better to go for Private Limited Company. If you need to raise capital from public, the process of converting it to Public Limited Company later when the need arises, is fairly simple and not very time consuming either.
- Need of funds as also the sources of funds. If significant funds are required, and that too from financial institutions, they prefer business structure(s) which would facilitate their participation in business operation, if need arises. They also prefer structure(s) where law enforces greater transparency in operations and reporting.
- Statutory requirement. Some business are required by law to be only in particular format. For example, one cannot run schools and colleges except in the form of charitable trusts, societies or Section 8 Companies. Strictly speaking, in India, education cannot be run as a business, but only as a charity.
- Profitability of operations, especially in initial years, and therefore consequential tax implications (Income-tax on the entity, and tax implications on distribution of profits to/amongst owners as dividend or remunerations etc). As of now, if someone is expecting an annual net income of Rs. 20 lakhs for a few years, it is better to go for Proprietorship rather than to any other structure. It has a couple of exceptions, viz. if there is involvement of some outsider, then obviously, you will need to think in terms of Partnership or Limited liability Company. Partnership firm and the Company have their own limitations and handicaps.
- Financial flexibility. When it comes to financial flexibility, Proprietorship and Partnerships are the best. Company structure is too rigid and cumbersome and, in fact, at times frustrating and annoying. Even if you (or your family) owns the company entirely, and there are accumulated profits therein, taking out money would involve paying income-tax again on the dividend. Even a temporary loan is not possible. A private limited company cannot raise capital from non-corporate entities or individuals who are not directors, except by following a very lengthy, costly and irritating procedure. Even a director cannot give loan to the company, if those funds have been borrowed by the director from somebody else.
- Compliance Costs. For small business, the format of a company is like a white elephant. Costs are high, flexibilities are poor. Even for middle sized businesses, it becomes cumbersome and costly to comply with all requirements under Company Law and other statutes except with the help of specialists or professionals who are, quite often, not conversant with or refuse to consider business realities and exigencies.
- Expected tenure of business. If the business or project is not likely to last long, it is advisable to not to set up complex entities, like Company, which have perpetual succession and even their winding up has legal, financial and tax complications.
Very effective and precise