Choosing the Right Business Structure

Want to become an Entrepreneur and start your own Venture. The first question that comes in your mind is what kind of Business Structure to choose. You start speaking to various entrepreneurs and different opinions further put you in a fix. The Structure itself is not right or wrong and the perfect choice is one which suits to your situation.

This article makes an attempt to compare all the pros and cons of the most common Business Structures in India so that the Entrepreneur can make an informed call.

The compliances of a business are largely dependent on the business structure, it is very important to choose the appropriate business structure. A comparison of the various business structure should be made for choosing the right business structure. A comparison of advantages and Shortcomings of most commonly used Business Structures in India is given below:

1. Limited Liability Company:

A Limited Liability Company can be registered under Companies Act, 2013. Companies are generally of two types: (1) Private Limited Company, (2) Public Limited Company.

Recently the concept of One Person Company (OPC) is also introduced in India.

Advantages:

• Limited Liability of Members: One of the biggest advantage of incorporating a Company is the limited liability of members. In case of losses in business, the liability of members is limited to the amount of Shares subscribed by them. They are not required to contribute to the shortage from their personal assets. Here it is important to mention that even though the liability of members is limited, it may become unlimited in certain situations. For example: The Banks usually ask for the Personal Guarantee from Promoters and Directors. In those situation the liability of promoters towards that Bank Loan would be unlimited because of Personal Guarantee.
• Investor and Management can be separate: In case of a Company, the shareholders invest the money in the Company, whereas the Company is managed by the Directors who are elected by the shareholders. However Shareholders can also elect themselves as Directors of the Company. The shareholders are not responsible for the conduct of the Business of the Company, hence their role and responsibility towards the Company is limited. Therefore the investors usually prefer the Company structure for the investment.
• Better Market acceptability: Company Structure is subject to more regulatory control and hence enjoy better market acceptability. Company Structure is considered to be more permanent structure and employees generally prefer to work in a Company. The Companies Act provides specific guidelines for the Accounting Standards, Balance Sheet formats applicability for the Company. Hence the Company financials enjoy more credibility.
• Separate Legal Entity: The Company structure enjoys separate legal personality of its own. The Company and its shareholders are considered separate. The Company can contract with third parties in its own name, company can own properties in its name.
• Permanent Structure: Company is considered to be a more permanent structure. In case of proprietorship, the firm gets dissolved on the death of the Proprietor. However in case of a Company, the Company even survives the death of all Shareholders.
• More suitable for JVs/FDI: Company Structure is more suitable for Joint Ventures. The shareholders agreement is easily structured in the Company as compared to other structures. Investors prefer to invest in a Company as compared to other Business Structures. Earlier the FDI in LLP was only allowed under Specific Approval Mode, however now the FDI in LLP is also allowed under Automatic route. Other structures are not allowed to receive FDI.
• Liquidity to investors: Company structure provides more liquidity to investors. In case of Partnership Firm, generally the partners need the consent of other partners to sell their share to an outsider. However in case of Company, the shares can be easily transferred. In case of Public Limited Company, the shares are freely transferable, whereas the shares of Private Company can be easily transferred subject to reasonable restrictions. Company can also go listed to provide even more liquidity to Investors.
• Most suitable structure for large projects: The ability of Company to raise big capital from multiple investors, flexibility in Capital Structuring and management, ability to become public, the limited liability of shareholders makes it most suitable structure for large projects.
• Tax Shortcomings: The Company structure provides certain Tax Shortcomings as well. Generally the startup companies incur losses initially and they need to carry forward these losses to set off against future profits. Also generally the shareholders sell their shares to another investor/participant in the business. Now in case of a Company, the losses can be carried forward upto the point the existing shareholders still own 51% shareholding in the Company. Whereas in the case of a Partnership firm, any reduction in share of profit of existing partners would make the firm loose the benefit of carry forward of proportionate losses. Certain provisions under Income Tax Act, provide higher tax deduction for a Company Structure. Also the tax rate for a Company with less than Rs. 400 Crore Turnover is 25% as compared to 30% rate for Partnership Firms. Unlike restriction on Partners’ remuneration, there is no such restriction on the Directors Salary in Income Tax.
• Easy Insolvency Procedure: Insolvency and Bankruptcy Code (IBC) provide for a fast Insolvency Procedure by the involvement of Professionals. The Code at present is only applicable to Companies.
• Easy Exit and Succession planning: Company structure provides more flexibility of structuring the Exit and succession planning from the Business. In case the promoters want to exit from the Business, they can transfer the shares and the Company continues to operate under the existing name and structure. Since the Company is a separate legal personality, all assets, liabilities, registrations etc. continues in the name of the Company.

Shortcomings:

• High Compliance Cost: Company Structure is subject to more regulatory compliances, hence there is a high compliance cost. Therefore Company Structure is not preferred for very small businesses.
• Several Restrictions on Management: There are many regulatory restrictions on the Company Management like restriction on loan to Directors, related party transactions etc. Hence the Company Management works under certain regulatory restrictions in a Company Structure.
• Dividend Distribution Tax: The Distribution of Profits by a Company is subject to an additional Tax called as Dividend Distribution Tax. This creates additional tax liability on the Company Structure. Further if the individual shareholder receives dividend of more than 10 lacs in a year, he is also subject to additional tax @10%. Therefore the distribution of profits by the Company entails a high tax liability on the Company Structure.
• Minority Oppression: The Company structure operates under democratic principle, hence all decisions are taken by majority. Hence there are possibility of minority Oppression in case of Company.
• Not Suitable for very small or temporary ventures: Due to high Compliance Cost and regulatory controls, it is not suitable for very small or temporary ventures.
• Difficult Exit: It is generally said that it is very easy to give birth to a company but difficult to make it die. Although there is a simplified provision for the strike off the Company, but the simplified provision can only be exercised if there are no assets and liabilities in the Company and the company is not in business for more than 2 years. In absence of this compliance, the Company need to go through the detailed winding up process, which entails unnecessary cost to the Company.

2. Limited Liability Partnership (LLP):

A Limited Liability Partnership can be registered under Limited Liability Partnership Act, 2008. LLP structure offers the benefit of a Company structure to a Partnership Firm with simple Compliances.

Advantages:

• Limited Liability of Partners: The biggest advantage of a Company Structure was Limited Liability of Shareholders. However the LLP structure provides this benefit with simple compliance structure as compared to Company.
• Less Compliance Cost than Company: The regulatory control on the LLP is lesser than the Company and hence it requires less compliance cost than the Company. The Audit of LLP is not mandatory unless it crosses the Turnover/Capital criteria.
• No Dividend Distribution Tax: There is no Dividend Distribution Tax in LLP and the share of profit received by Partners from the LLP is exempt in their hands. Hence the distribution of profits is easy in case of LLP as compared to a Company.
• Flexible Decision making / No Meetings required: The LLP enjoys complete flexibility to provide the process of decision making in Partnership Deed. However in the case of Company, the decisions are taken by passing resolutions in meetings of Board/Shareholders.
• Less restriction on Management: There are various restrictions on the Company Management, whereas the LLP provides more flexibility to management in matters like giving loan to partners or related party transactions etc.
• More suitable structure for Professionals: LLP is generally considered to be preferred structure for Service Providers. For example: A Company is not allowed to conduct Audit function, hence the Chartered Accountants form themselves as Limited Liability Partnerships.
• Easy to create and Easy to wind up: LLP structure is comparatively easy to create and wind up. The winding up process of LLP is comparatively easy as compared to a Company.

Shortcomings:

• Management and Investor can not be separate: In case of LLP there are only Partners as compared to a Company Structure where the Company is owned by the shareholders but the same is managed by Directors. However in the case of LLP, the partners who participate in the management of the LLP are called Designated Partners and other Partners are called Partners. However the structure is less flexible than the Company.
• More compliances than conventional Partnership: Although LLP provides for the simple compliances than a Company structure, but the Compliances in LLP are higher than a Conventional Partnership.
• Restriction on Partners Remuneration in Income Tax: There are certain restriction of the partners remuneration under Income Tax. Hence if the LLP pays extra remuneration to Partners, the same is disallowed under Income Tax. The LLP is subject to higher tax rate of 30% as compared to the concessional rate of 25% in case of Company with Turnover of less than Rs. 400 Crores.
• Possibility of Disputes in Big Partnerships: LLP Structure is considered to be more suitable for Business upto a certain size. Company structure is considered to be more suitable for big size businesses. The management of LLP is done with the consensus of partners whereas the Company is managed by the majority consent, hence the decision making is easy in case of Company when the number of participants is high.
• Not capable to raise money from Public: The LLP can not be listed to raise money from Public. Hence LLP structure is not suitable for Business which require raising of Capital from Public.
• Difficult Exit by Partner: The Exit from LLP structure is difficult than the Company. The exit of Partner would require restructuring of the Partnership Deed and creates tax implications for the LLP as well. Whereas the shareholder of a company can easily sell its shares.

3. Partnership:

An Unlimited Liability Partnership firm can be established under Indian Partnership Act, 1932.
A Partnership firm can be registered or Unregistered Partnership Firm.

Advantages:

• Low Compliance Cost: The normal partnership firms are subject to very minimum compliances. They are not required to make any filings with ROC and they are only required to file their Income Tax Returns. There are minimum regulation to the management of Partnership firms.
• Easy to start / Easy to close: A normal partnership can be created very easily. The Partners can execute a Partnership Agreement on a Stamp Paper and get it notorised to create the Partnership firm. The registration of Partnership firm is also not mandatory.
• Suitable for Temporary / very small business: The Partnership Firm is more suitable for Temporary or very small business. The Company or LLP structure are subject to compliance costs and hence they are not suitable for very small businesses.
• Complete Autonomy/ No restrictions on Management: The Partners in a Partnership firm are not subject to any specific regulatory requirements for their internal management. The Partnership Act, 1932 provides for minimum requirements for the conduct of business and there are actually no restriction on the Partners for conduct of their business.
• Presumptive Tax Provisions: Partnership Firms can enjoy the benefit of Presumptive Tax Provisions under Income Tax Act and enjoy the lower compliances under Income Tax.

Shortcomings:

• Unlimited Liability of Partners: The biggest disadvantage of Partnership is the unlimited liability of Partners. Hence the Partners are personally liable for the debts of the Firm. This makes this structure more risky than other structures.
• Partners can’t sue in case of Unregistered Partnership: Since registration of Partnership is not mandatory, most of the partnership firms are running as unregistered partnership. In case of any dispute among partners, they can’t sue the Partnership firm.
• Limit on Partners’ Salary in Income Tax: There are limits on the salary of partners under Income Tax and if the Partnership firm pays salary higher than those limits the excess is disallowed under Income Tax.
• Disputes among Partners: Since the partnership firm operates on consensus basis, there are more likelihood of disputes among partners. In case of big partnerships, the possibility of disputes is even higher.
• Not Suitable for Big Size Business: Because of unlimited liability, limit on the number of partners and the inability to raise the capital from Public, it is not suitable for Big Size Business.
• Less Permanent: A Partnership Firm is considered to be less permanent structure and in case of death, incapacity or insolvency of Partner, the firm is also dissolved. The average life of partnership firms are generally found shorter than the Company.
• No Separate Entity: The Partnership firm has no separate entity of its own. All the Assets and Liabilities of Partnership firm are considered to be jointly owned by the Partners.
• Not suitable for JVs/FDI: Structuring of JVs and investments are difficult for Partnership Firms. In today’s world different structures are used for the funding of business, whereas the Partnership firms are not capable to use certain structures for funding the business.
• No Separation between Investor and Management: Unlike the Company structure, where the Shareholders and Directors are separate, there is no difference between investors and management in case of Partnership Firm. There are only Partners in Partnership firm who make the investment and also run the business.