This article has been written by Ritesh Singh pursuing Diploma in Corporate Law & Practice: Transactions, Governance and Disputes and has been edited by Oishika Banerji (Team Lawsikho).
This article has been published by Sneha Mahawar.
A business organisation can be owned and organised in many ways, each having its own advantages and disadvantages which are required to be analysed by the business owner’s for select the optimal structure of business which suits the organisation according to their needs. The decision regarding the form of organisation is crucial as it determines the entrepreneur’s power, control, risk, responsibility, and the allocation of profits and losses. It is essential to carefully consider all the factors before making a long-term commitment to a particular form of business. The selection of a suitable form of business organisation is a critical entrepreneurial choice that significantly influences the success and growth of a business. It affects the distribution of profits, the level of risk associated with the business, and other relevant factors.
Once a form of business organisation is chosen, it can be challenging and cumbersome for businesses to switch from one form to another form, as it requires winding up and dissolution of the existing organisation. Conversion process involves complex issues and procedures that can waste time, effort, and money and closure of a business leads to the loss of opportunities, capital, and employment. The amount of risks and liabilities, as well as the owners’ ability to bear them, are also important considerations in selecting the appropriate business entity.
Therefore, to make an optimal choice of the form of business organisation should be made after careful consideration of all aspects and check for the suitability of each form of business with the entrepreneur’s business ideas. Several factors need to be taken into account when selecting the appropriate form of business organisation. These factors include the division of profits, control, risk, legal formalities, flexibility, and other relevant considerations. It is essential and advisable to thoroughly analyse and assess all these aspects during the planning stage and choose the right form of organisation that aligns best with the business’s nature and requirements. Since the decision to choose a business organisation takes place at both stages, first at the initial stage of starting a business and at a later stage to meet growth and expansion needs, it is essential to address this issue at both the stages of business priorly in order to reduce risks and liabilities,and avoid wastage of time, effort and money. This article analyses as to how a business organisation can make optimal choices for its betterment.
Why is it essential to choose the right structure of a business organisation
While choosing the right structure of a business organisation, it is essential to check the needs of the entrepreneur and look for various factors which are required to be assessed while selecting the particular type of business organisations. Factors which are required to be checked are stated below as follows:
- Legal and regulatory compliance: Different business structures have different legal and regulatory requirements. Selecting the appropriate structure ensures compliance with relevant laws and regulations, reducing the risk of penalties, fines, or legal issues.
- Liability protection: Certain business structures, such as limited liability companies (LLC’s) and corporations, offer personal liability protection to the owners. This means that their personal assets are protected in case of business debts or legal claims. Choosing the right structure can help safeguard personal finances and assets.
- Tax implications: Business structures have varying tax implications. Some structures, such as sole proprietorships and partnerships, pass business income and losses through to the owner’s personal tax returns. Others, like corporations, are subject to separate taxation. By selecting the right structure, businesses can optimise their tax strategies and potentially reduce their tax burden.
- Funding opportunities: The choice of business structure can impact a company’s ability to raise capital. For example, corporations can sell shares of stock to raise funds from investors. Certain structures may also be eligible for government grants, loans, or other financing options. Selecting the appropriate structure increases the chances of accessing the desired funding sources.
- Scalability and growth potential: Different business structures offer varying levels of scalability and growth potential. Some structures, such as corporations, allow for easier transfer of ownership and investment opportunities, facilitating expansion. Others may be more suitable for small, owner-operated businesses. Choosing the right structure aligns with the growth aspirations of the business.
- Management and decision-making: Business structures determine how decisions are made and how the organisation is managed. Structures like partnerships involve shared decision-making, while corporations have a more structured hierarchy. Selecting the appropriate structure ensures that the organisation’s management and decision-making processes align with the owners’ preferences and goals.
- Perpetuity and succession planning: Certain business structures, such as corporations, have perpetual existence, meaning they can outlive their founders. This can be advantageous for long-term planning and succession purposes. Choosing the right structure allows for effective succession planning and ensures the continuity of the business beyond the current ownership.
In summary, selecting the right structure for a business organisation is crucial as it impacts legal compliance, liability protection, taxation, funding opportunities, scalability, management, and long-term planning. By considering these factors and aligning the structure with the business’s goals and requirements, entrepreneurs can set a solid foundation for their venture’s success and growth.
Types of business organisation
- Sole Proprietorship- It is a form of business organisation, wherein one person owns all the assets of the business. To form a sole proprietorship, there are no legal formalities required except the appropriate licensing to conduct the business.The proprietor reports income or losses from the business along with his personal income tax return.
- Partnership firm- Partnership firms are created by drafting a partnership deed among the partners. Partnership deeds are registered to make a partnership firm and such firms are governed by the Indian Partnership Act, 1932. According to Section 464 of the Companies Act, 2013 it empowers the Central Government to prescribe the maximum number of partners in a partnership firm but the number of partners cannot be more than 100. The Central Government has prescribed the maximum number of partners in a firm to be 50 vide Rule 10 of the Companies (Miscellaneous) Rules, 2014. Thus, in effect, a partnership firm cannot have more than 50 members”.
- Hindu Undivided Family (HUF)- A Hindu family can come together and form a HUF. HUF is taxed separately from its members. Businesses can select HUF and can save taxes by creating a family unit and pooling it in assets to form a HUF. HUF has its own PAN and files tax returns independent of its members.
- Limited Liability Partnership (LLP)- Limited Liability Partnership is an alternate corporate business entity that provides the benefits of limited liability of a company but allows its members the flexibility of organising their internal management on the basis of a mutually-arrived agreement, as is the case in a partnership firm, introduced in India by way of Limited Liability Partnership Act, 2008.
- Co-operative Society- A cooperative organisation is an association of persons, usually of limited means, who have voluntarily joined together to achieve a common economic end through the formation of a democratically controlled organisation, making equitable distributions to the capital required, and accepting a fair share of risk and benefits of the undertaking.
- Section 8 of the Companies Act, 2013 – The provision deals with the companies established for promoting commerce, art, science, sports, education, research, social welfare, religion, charity, protection of environment or any such other object. Provided the profits, if any, or other income is applied for promoting only the objects of the company and no dividend is paid to its members.
- One Person Company- An OPC means a company with only 1 person as a member shareholder. He can make only 1 nominee and shall become a shareholder in case of death or incapacity of original stakeholder.
- Private company- Private company is a company which has the following characteristics:
- Shareholder’s right to transfer shares is restricted.
- Minimum number of 2 members in the company.
- Number of shareholders is limited to 200.
- An invitation to the public to subscribe to any shares or debentures or any type of security is prohibited.
9. Public Company- A public company is a company which has the following characteristics:
- Shareholders’ right to transfer shares is not restricted.
- Minimum 7 members.
- An invitation to the public to subscribe to any shares or debentures or any type of security is permitted.
How to select an optimal business structure and factors governing suitable form of a business organisation
Factors governing the suitable form of business organisation:
- Nature of business activity: The nature of business activity carried out by a business organisation plays a key role while selecting the type of business structure of such organisations. In small trading businesses, rendering of personal services preference of sole proprietorship is predominant. Partnerships are suitable in all those cases where sole proprietorship is suitable provided the business is carried on a slightly bigger scale. For example finance, trading and real estate industries prefer partnership forms of organisation. For large scale businesses, company and LLP are more suitable forms of business organisation.
- Scale of operation: If the scale of operation is too small,sole proprietorship or one person company (OPC) is preferred, if the scale is modest, LLP or partnership is preferable and if the scale is large,company form is suitable for such business organisations accordingly.
- Time, cost and regulatory framework of incorporating different forms of business organisations: Another reason while selecting the appropriate business structures for entrepreneurs is the amount of time required to incorporate such entities and the amount of cost involved while incorporating such different entities
- Sole proprietorship: In case of sole proprietorship, no incorporation is required as it is not considered different from its owner and whereby no separate documentation is executed and it is immediately active and running subject towards obtaining any business licence required to commence such business.
- Partnership: In case of partnership, a stamped partnership deed is required for ensuring enforceability and only the cost of partnership agreement is borne by the partners and no incorporation process is required to be followed.
- Limited Liability Partnership (LLP): It requires a detailed incorporation and filing process which includes an execution of stamped LLP agreement. It requires more cost and time as registration is required with ROC and also LLP has statutory compliance requirements which are required to be fulfilled. But the compliance is less than those of companies.
- Company: While incorporating a company, a detailed incorporation and filing process is to be followed along with filing of Articles of Association, Memorandum of Association and is required to be submitted to ROC. It takes more time to incorporate and needs professionals to draft the constitutional documents (MOA & AOA) properly and has statutory and annual compliance under the Companies Act, 2013, which are duly required to be followed.
4. Capital requirements: Capital is an important factor which affects the choice of business organisation, depending on the capital requirements of the business organisation the entities can select their business structure accordingly. In cases where entities require huge capital it should be organised as companies, whereas enterprises requiring smaller investments can opt for sole proprietorship or even as partnerships. Companies are viable as an option in order to attract investors and raise capital as investors are assured with limited liability,easy accessibility and ownership can be transferred to other investors.
5. Amount of risk and liability: Risk and liabilities of an organisation depends on its size, the smaller the size of the business, the proportional risk and liability of such entities is much smaller. In case of sole proprietorship, the amount risk is small, the sole proprietor is personally liable for all the debts of the business to the extent of his entire property.In case of partnership, partners are individually and jointly responsible for the liabilities of the partnership firm.whereas in case of Companies and LLP creditors can only force payment of claims only to limit of the company’s and LLP assets.
6. Tax implications: Tax is an extremely important factor for business organisations while selecting their appropriate structure as it directly impacts the post-tax retained earnings of the business and distribution of money to its owners. In case of sole proprietorship, the income is added to its owner’s personal income and personal income tax is applied to it. The highest rate of tax is applicable only to the portion of the income which crosses a specified threshold (for the assessment year 2022-2023 the highest rate is 30 percent plus 4% health and education cess when the income exceeds 10 lakhs). Whereas LLP and companies are taxed at the same flat rate of 30 percent of their profits. In companies, distribution of dividends attracts dividend distribution tax (DDT) of around 20 percent on the profit that is paid to shareholders which reduces the total income of shareholders. In case to benefits of limited liability and lower tax rates together, an LLP is much suitable as a form of business organisation in such cases due to lower statutory and compliance requirements than companies.
- Division of profit: Profitability of a business organisation is essential for its existence and has a huge impact on the selection of a business organisation.An entrepreneur who intends to keep all the profits of the business will prefer sole proprietorship, but his personal liability is also unlimited. Whereas, in case of partnership, the profits are distributed among the partners of the firm post payment of all taxes. In case of companies, the profits are distributed among the shareholders in proportion to their shareholding and the rate of dividend is decided by the board of directors through the approval of shareholders. Companies can also issue bonus shares, ESOP’s to its employees. In case of a listed company, the equity shares are tradable on the stock exchanges,which enables the shareholders to exit the company at their own discretion.
- Transferability of ownership: In case of sole proprietorship, no perpetual succession is allowed. With the death of the sole proprietor, the business ceases to exist. In partnership, ordinarily upon the death of a partner, the partnership firm is automatically dissolved under Section 42 of the Indian Partnership Act,1932.
- Independence: If an entrepreneur wants freedom in business with little intervention from the government he should go with sole proprietorship or partnership, as LLP and company are subject to strict government regulations and are required to follow statutory and annual compliances.
Why do entrepreneurs prefer to incorporate companies
Reasons why entrepreneurs prefer to incorporate companies as a choice of their business organisation:
- Limited liability on all shareholders of the company and liability extends only to the proportion of shareholding held by the shareholder.
- Perpetual succession.
- Ease of raising investments and obtaining loans from foreign as well domestic investors and banks
- It provides employees stock option plans(ESOP’s) as an incentive to employees.
- Provides easy exit options to investors at their own discretion.
- Provides flexibility of administration and divergence between ownership and management.
- In a case where an entrepreneur intends to increase his scale of operation of his business.
When should you not incorporate a company
Reasons when not to incorporate a company are provided hereunder:
- Just for the purpose of getting affiliation of Pvt Ltd: Often entrepreneurs think that it’s better to incorporate a company with a name of ‘private limited’ than as proprietor or a partnership firm to increase the credibility of their business among people. But incorporating a company leads to various compliance requirements apart from the credibility.
- Just for limited liability not considering the scale of operations: Often entrepreneurs tend towards limited liability and not assess their business scale.When the company’s scale of operation is too small there is no need to incorporate a company just for the sake of limited liability and such entities can prefer sole proprietorship or partnership as choice of business structure of such organisations.
- Non-disclosing nature: If you don’t want to disclose your turnover, profitability as public information, do not select a company as a choice of your business organisation as such information is easily accessible from the MCA’s website.
Every business structure has its own advantages and disadvantages and it really depends upon the choice of entrepreneur to select the optimal choice of business structure for his business organisation taking in consideration of all the factors like the amount of risk and liabilities, tax implications, scale of operation, the nature of business activity carried out the business, division of profit and look for all the statutory compliance and regulatory framework required to be fulfilled by business organisation. Structuring a business as sole proprietorship firm is applicable for small scale operation of business and it requires no incorporation and documentation except to obtain the business licence required for such business. It can be started immediately and incurs less cost and time to start a proprietorship firm. Whereas, structuring a business has a partnership, is tax efficient and relatively more flexible, but it is risky to go for partnership due to the risk of personal liability of promoters. A LLP is more preferable with certain kinds of business such as law firms or a business in its initial phases as in LLP there is difficulty to raise capital from large investors and inability to access cheap foreign loans. A company is preferred in case the business organisation needs to increase its scale of operations to a large extent, raise capital or borrow loans from domestic and foreign banks. In such cases, a company can be the optimal structure for such a business organisation. It may not always be a best idea to incorporate a company due to increased tax implications and excessive record keeping, filing and compliance requirements, it may not be a suitable choice to structure every business as a company from the beginning. Thus, it entirely depends on the needs and objectives of the business organisation and after analysing all the factors a suitable choice of business organisation must be selected.
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