A step by step guide to selecting an appropriate legal structure for your business
When you go for shopping with nothing specific on your mind, there are two things that usually go wrong – 1) You buy something absolutely unnecessary 2) You spend too much on something worth too little. Shopping may be for fun; however, business isn’t. Selection of an appropriate business structure for your business firstly ensures that you don’t land up into an ugly mess later. Secondly, a good business structure ensures that you don’t spend too much time or money in compliance or red tapes, which are unworthy for your business growth. Changing the business structure after commencing business is complicated. Therefore, successful entrepreneurs are wise at choosing their business structure at the beginning of their business. So, if you are setting up a new business, here’s a step by step guide for selecting your business structure while setting up a business in India, straight from a Chartered Accountant’s archives.
Step 1 – Who will be the financer of the business?
The legal structure of a business is heavily dependent on the financers of the business, as the same decides who takes the profits from the business and the mode in which profits can be availed. Here are some illustrative recommendations:
- If the money is entirely your own, you can start a Sole Proprietorship Firm where profits can be freely withdrawn, however, the same comes with unlimited liability. This drawback can be overcome by incorporating One Person Company (OPC) under the Companies Act.
- If you are getting into a business with a friend or a group of friends, you have the option to form a Partnership firm or incorporate a Limited Liability Partnership (LLP), sharing profits at a pre-decided rate. In a partnership firm, every partner has unlimited liability, while in an LLP the same drawback can be overcome.
- If you wish to involve Angel Investors, Venture Capitalists or such outside investors into your business, you will require a business structure where Directors (people who run the business) and Financers (people who contribute funds in the business) are distinct. This is possible with a Private Limited Company. You can invite investors to finance and meanwhile, you can be the director of your business (and also hire other professionals as directors), taking a fixed pay every year for running the business and keep a portion of shares of the company by way of Employee Stock Option Plans (ESOPs) or by direct holdings.
- If you wish to raise funds from the public at large by issuing prospectus, a legal invitation to invest, you must form a Public Limited Company. Usually, only a public limited company can enter the stock markets and raise money from the public.
- If you are a foreign investor setting up a business in India, you will have to seek specific permission from Reserve Bank of India (RBI) before investing by way of Sole Proprietorship Firm or Partnership Firm. However, for investments in LLPs, Private or Public Limited Companies, mere compliance with terms and conditions under Automatic Route is sufficient.
- If you are a Person of Indian Origin (PIO) or a Non-Resident Indian (NRI), you are free from the restrictions mentioned above, with respect to investing by way of Sole Proprietorship firm or a Partnership firm, provided you do not repatriate the funds outside India.
- If you belong to a Hindu, Buddhist, Jain or Sikh community, you can run your business as a Hindu Undivided Family (HUF), a separate entity which is automatically formed when a person marries, where all members of the family i.e. Spouse, lineal descendants and their wives, and unmarried daughters, have equal rights to the profits of the business.
Step 2 – What kind of market are you serving to?
If dealing with end-users of a product or service, the legal structure may not matter as such, however, if the consumers of your product or service are large corporates, they may have their own specifications or requirements of business structure. Here are some illustrative considerations:
- If you are dealing with large corporates, it is important to note that certain corporates do not conduct large scale businesses with unincorporated entities like Sole Proprietorship Firms or Partnership Firms, and instead prefer LLP or a Private Limited company.
- If your end consumers are Government entities, or if you are participating in government tenders it is important to consider their preferences or the requirements of such tenders. Similarly, if your business operates from a designated Special Economic Zone (SEZ) or such Industrial Parks, it is important to comply with the rules and regulations of such industrial parks with respect to the business structures.
- If your business involves large scale importing or exporting of products, your business risks are usually higher than usual and therefore, it becomes important to form a limited liability entity.
- If your business requires licensing from certain Government authorities e.g. telecommunication, liquor beverages, pharmaceuticals, etc. it is important to consider the terms and conditions of such licenses.
Step 3 – Are there any Government Subsidies or Tax incentives?
When you are starting a business, which is promoted by the Central or a State Government, or tax incentives, it is imperative to consider the terms and conditions of such schemes, as you may not want to lose out on such benefits which reduce your project cost. Further, it is important to maximise such benefits by choosing the appropriate business structure. Here are some illustrative examples:
- Government of India, to promote the textile industry, provides 10-30% capital subsidies on purchase of modern machinery in the textile industry under its different schemes. However, these schemes usually have a ceiling limit on the maximum eligible capital expenditure for the purpose of subsidies. An entity can maximise the benefits of such Government subsidies by incorporating multiple entities instead of investing through one single entity. Such business decisions have to be planned and made upfront before investing.
- Under the Income Tax Act, a 50% tax holiday for a period of 10 years, is available to entities in the specified hotel businesses. However, such benefits are available only if the entity operates as an Indian Company (private or public) registered under the Companies Act, with specified amount of paid-up capital.
Step 4 – Which is the tax optimising business structure?
The tax departments offer different tax regimes based on the types of entities. The tax regimes are usually simpler for Sole Proprietors and Partnership firms, while complicated for Companies and other types of institutions. The trade-off between the tax regimes of types of entities needs to be considered before finalising the business structure. Here are some illustrative examples:
- Under the income tax act, for small scale businesses, a sole proprietorship firm is useful to avail the benefit of exemption limit of INR 250,000 and the various personal tax investments/expenses as deductions from income. Further, they can avail reduced tax slabs, as compared to corporate entities where they would end up paying 25-30% tax and further tax on dividend distribution.
- As per the latest amendments in the income tax act, new manufacturing entities, making capital expenditure, are eligible for a tax rate as low as 15%. However, you would benefit from the same, only if your business structure is that of a Private or Public Limited company.
Step 5 – What are the compliances and the cost of compliance?
Compliances can be handled by hiring a good internal team and a team of external experts. However, the same can be avoided in the first place, by choosing the right business structure. Therefore, it is important to consider 1) Registration Compliances 2) Annual Compliances. The Registration compliances are one time, however, in the case of companies is a lengthy process. Similarly, the Annual Compliances and extent of information required to be disclosed are also higher in case of incorporated entities. Compliances keep changing and therefore, this factor must be considered after considering the former factors. Some illustrative examples of frequently committed mistakes are as follows:
- Small businesses often incorporate a Private Limited Company, instead of incorporating a LLP. The purpose of limited liability is served with the formation of LLPs, however, businesses going for forming a private limited company and end up facing unnecessary compliances like detailed Annual Returns, maintaining secretarial records, etc.
- Businesses which do not intend to raise money from the public often form Public Limited Company instead of a Private Limited Company and end up complying with additional compliances in terms of capital, directors, shareholders, procedures with respect to raising capital, etc.
Step 6 – What are the needs with respect to continuity and flexibility?
This is a final factor which an entrepreneur must consider before finalizing the business structure selected. Entrepreneurs may initially start the business as a simpler entity, and convert itself when a business checkpoint is triggered e.g. Sales turnover, need for further funding, expansion plans, etc. or when the benefits of current legal structure have been availed. However, usually it is not recommended to change the legal structure. This should be opted for, only when the benefits are very certain and there are no restrictions to conversion. Business combinations which are temporary in nature can be facilitated by way of joint ventures. The flexibility of additional funding, adding partners or professionals to manage the business, the exit options for the business must also be considered.
Efforts today, benefits tomorrow!
Entrepreneurs often do not pay much heed to the selection of appropriate business structure and end up regretting the lack of planning later. The selection of business structure may be a tiresome issue for certain entrepreneurs due to the complexity of businesses or lack of knowledge. In such cases, it is always recommended to take professional advice, instead of giving away these benefits, as some efforts today, would reap several benefits tomorrow