One of the most important things to do while starting a new business is to choose the best legal structure. It's important to know the differences between various structures and the risks and benefits involved in each.
We have therefore put together this guide to help you figure out what is best for your business.
The most common business structures are sole proprietorships, partnerships, limited liability partnerships, and limited liability companies. There are also other structures like one person companies and not for profit entities which are also used. Here, you'll learn about each one in detail to help you choose the right fit for your business, as well as a not for profit entity you might consider for a new charitable business.
What type of structure you choose will make a big difference over the life of your business. It can have significant tax implications, as well as implications for your personal level of risk. It is not a decision that should be made lightly.
Below, we examine each common business structure in detail.
A sole proprietorship is the simplest type of business structure and the easiest to form and maintain. A sole proprietorship is basically an individual operating on his own i.e. one-man organisation where a single individual owns, manages and controls the business. In a sole proprietorship, no separate legal entity is created. Sole proprietorships are one of the most common forms of doing business in India used by micro and small businesses. To start a sole proprietorship all you need is a bank account and tax registrations in the name of the business.
Because of the simplicity of the sole proprietorship, the way that your taxes are handled is also fairly simple. The taxes of the sole proprietorship would "pass through" to you, meaning you report any profit or loss on your own taxes.
One of the biggest drawbacks to a sole proprietorship is that you can be personally liable for business losses. That's because in a sole proprietorship, there is no separation between you as a person and you as a business, so anything you own, in terms of assets, may be taken over by any kind of creditors or the public to whom you are facing liability. Another drawback is that it may not be very easy to raise money since investors cannot own stakes in the sole proprietorship.
There is no process of registration specified for a sole proprietorship, however tax registrations and licenses such as Permanent Account Number (PAN), Goods and Services Tax (GST) would need to be obtained.
A sole proprietorship is a good idea if you are a entrepreneur with a small business and you are planning to keep it that way. It's very easy to form (there are hardly any filings other than the tax registrations to be obtained) and you can get focused on starting your business right away. It's also very cheap to get started.
Especially if your business may not be facing a high level of risk, a sole proprietorship might be for you. A sole proprietorship wouldn't be recommended if, let's say, you ran a business that dealt with large amounts of other people's money on a regular business, or really any area where the risk of being liable for something serious is high.
If a sole proprietorship is the simplest business structure for an individual looking to operate their own small business, a partnership might be considered that for two or more people.
In a partnership, the two or more "partners," as they are called, each generally have a say in how the business runs (depending on the structure of the partnership) and each own a piece of the business, including its profits and losses.
Partners are responsible for everything: all the profits, any potential losses, any liabilities that might come up, and general responsibility for the company, including the amount of work done. If the partnership incurs a liability, the partners are personally responsible for it.
Joint venture is a generic term for any type of business relationship between two parties for a limited time. A joint venture could be for a brand new business, or just one marketing promotion, or even just a project between two already-formed businesses. In a joint venture, the parties could decide to form a temporary partnership, with a Partnership Deed, but they don't have to: they can also retain their fully separate legal identities and just operate with a Joint Venture Agreement.
The formation of a partnership, is fairly simple. However, a written Partnership Deed is very important. Partners will need to figure out everything from how they'll run the day-to-day business to what happens if the business folds or if someone wants to leave.
As mentioned above, the basis of partnership formation is the written Partnership Deed, which sets out all of the details of the business relationship between the parties. You may also need specific licenses or permits for your particular business model.
A partnership is a good idea if you are running a small business with another individual or a few individuals. As with a sole proprietorship, it's very easy to form and you can get focused on starting your business right away. It's also very cheap to get started, just like a sole proprietorship.
If you're not sure of the trustworthiness of your potential partners, however, a partnership may not be the way to go for you, as you could be exposing yourself to a high level of risk just because of the actions of your partners. Either way, however, you should always have a well-written Partnership Deed in place.
A Limited Liability Partnership i.e. LLP is an alternative corporate business form that gives the benefits of limited liability of a company and the flexibility of a partnership. In a LLP, several partners are able to work together (unlike a sole proprietor). However, the LLP is a separate legal entity, is liable to the full extent of its assets but liability of the partners is limited to their agreed contribution in the LLP, unlike a partnership which is not a separate entity from the partners and is documented through a Partnership Deed.
The LLP can continue its existence irrespective of changes in partners. It is capable of entering into contracts and holding property in its own name. Further, no partner is liable on account of the independent or un-authorized actions of other partners, thus individual partners are shielded from joint liability created by another partner's wrongful business decisions or misconduct.
Mutual rights and duties of the partners within a LLP are governed by an agreement between the partners or between the partners and the LLP as the case may be. The LLP, however, is not relieved of the liability for its other obligations as a separate entity.
You can register a LLP on the website of the Ministry of Corporate Affairs (MCA) after obtaining the name approval for the LLP and obtaining DPIN (Designated Partner Identification Number) for partners. After incorporation the LLP Agreement must be filed within 30 days with the MCA.
LLP form is a form of business model which provides flexibility without imposing detailed legal and procedural requirements. It provides the benefits of partnership alongwith the advantage and reduced risk due to limited liability.
If you are a sole person setting up your own business a new possible structure that you may consider is a one person company.
The concept of one person company was introduced under the Companies Act, 2013. The biggest advantage is that there can be only one member in a One person company since a minimum of two members are required for incorporating and maintaining a partnership, Private Limited Company or a Limited Liability Partnership (LLP).
A One Person Company is a separate legal entity from its promoter, and it provides the advantage of limited liability to its sole shareholder, and is relatively easy to incorporate. Only a natural person who is a citizen and resident of India can act as member and nominee of a One person company.
A one person company can be formed by submitting the Memorandum and Articles of association through online forms on the website of the Ministry of Corporate Affairs.
It allows individuals to operate as a corporate entity with limited liability protection and is relatively easy to form. However, it can only be used for small businesses since a One Person Company must be converted into a Private Limited Company if it crosses an annual turnover of Rs.2 crores.
A Limited Liability Company, has largely become the preferred form of structure for many small and large businesses. The reason for this is because it has a lot of benefits of other types of business structures, without as much of the risk. A company is its own separate entity - often sometimes compared to a business version of a legal "person." In other words, the company is its own body separate and apart from you or any of the other owners, called "shareholders."
Companies can be used for small business or large ones. The main benefit of a company is that your personal assets are shielded from liability - hence the name, "limited liability" company.
Companies can, be formed for almost any purpose - for a group of people opening a lending company or a group of journalists starting a news platform.
Forming a company is more complicated than either a sole proprietorship or partnership, as it involves filing specific documents in a specific form with the Registrar of Companies on the website of the Ministry of Corporate Affairs.
The first step towards forming a company is obtaining an approval for the proposed name of the company from the MCA. Thereafter, the forms for incorporation can be filed. Prior to incorporation of the company, the Memorandum and Articles of Association i.e. the charter documents of the company need to be drafted and stamped with appropriate stamp duty. Once the forms are approved, the MCA issues a Certificate of Incorporation for the company.
An company is a good idea when you want to have the maximum amount of liability protection for your business. The company gets taxed on its own.
You might decide to set up a company if you are looking for a lot of growth potential for your business or if you knew you wanted to start bringing on shareholders right away. A company is a good idea if you plan to hire a lot of employees, as well.
It's probably not a good idea for very small business or individuals who don't plan to grow at a very high rate, as the expense of setting up and maintaining the structure, would easily make it more cumbersome than its worth.
A non-profit is different than all of the other business structures - and the difference is in its name. Non-profits are created for a different reason than just generating profit; usually, the reason is some kind of social cause.
Non-profits are eligible for tax deductions, and because of this, they need to have a specific purpose that is either charitable, religious, or educational.
If you'd like to run a business for a social cause, a trust, society or not for profit company are options to be considered for which by laws would have to be prepared.
The option for a non-profit is really only there if you have a business that is for charitable, religious, or educational purposes. Once you decide that you do, then you must ensure you really aren't running a business for profit and that the primary purpose is for another reason. If those requirements are met, the non-profit is the best choice for you.
When deciding what type of structure might be best for you, ask yourself the following questions:
- How much time and effort am I willing to put in to set up the business at the beginning?
- How much time and effort am I willing to put in to maintain the business over time?
- What will be personal liabilities be?
- Am I interested in easily raising capital?