Given the current government’s favourable policies, the Indian startup eco-system is at an all-time high. Many youngsters are leaving the comfort of their monthly salaries and are taking the plunge to give their ideas a direction and become an entrepreneur.
When starting out, while doing research about the market you are planning to venture into – understanding the scope of your idea, goes without saying. But the one important aspect to consider before starting on your own is to decide which is the right business structure for you from a legal and tax perspective. Putting your plans into action involves having to learn a completely new spectrum of skills that have so far been put in the “don’t need to know” box, with an understanding of the business structure topping the list.
One of the reasons why identifying the right business structure is so problematic is because there is no “one size fits all” answer, and deciding whether to run your business as a self-employment, partnership, limited liability partnership or company can change based on various circumstances.
I have listed down some basic information about business structures used in India, which will help you answer some questions before seeking out for professional help.
I strongly believe that one of the key traits of being a successful entrepreneur knows the limits of your skill-set and knowing when to outsource projects to people who have more experience in a specific area than you do. This helps in learning something new and getting the right advice.
In India, there are four main business structure types. Self-Employment or Sole Proprietorship, Partnership, Limited Liability Partnership and Limited Companies (Private & Public). The table below lists down some of the main features for each one.
Self-Employment Or Sole Proprietorship
This is the most basic form of business. In essence, you and the business are the same in everything but name. Everything gets reported through your personal tax returns. You are taxed as an individual on your net taxable income, after related business expenses, IT Deductions and other incomes if any have been taken into account. On taxable income, sole proprietors pay tax based on the slab rates as applicable to the owner.
There are some useful things that can be done with losses in the first years of business. So if your business is going to be loss-making at the outset, you might want to look into this further.
The main legal concern should be around liability. Running your business as a self-employment means you are personally liable for any claims against your business. This means that a creditor could call upon your own personal assets in the event of a claim.
From a slightly less worrying point of view, you have no legal obligation to prepare statutory accounts, and your filings for the company are limited to your tax return filings.
A partnership firm is not a separate legal entity distinct from its members. It is merely a collective name given to the individuals composing it.
Partnership firm is treated as a separate entity for taxation purpose. It is immaterial that partnership is registered or not registered.It is compulsory for a partnership firm to file a return of income.
Income Tax for partnership firm is calculated on the net income after making provisions for all expenses, partner’s salaries/interests, allowable deductions etc.
Income Tax Rate on Partnership Firm for A.Y. 2016 – 17 is Flat Rate of 30%. Long-term capital gains shall be taxable @20%, Short-term capital gains from shares/securities, subjected to Securities Transaction Tax @15%, Surcharge is payable @12% where total taxable income is over Rs. 1 Crore. Besides, Education Cess 2% and Secondary & Higher Education Cess @1% of income-tax and surcharge shall be levied.
Income Tax Rates on Partnership Firm for A.Y. 2017-18 have changed as follows: Long-term Capital Gain – 20%, Short-term Capital Gain u/s 111A – 15%, Other Income – 30%. Surcharge 12% where taxable income including capital gains exceedRs. 1 Crore. And Education Cess& Secondary & Higher Education Cess: 3% on the amount of income-tax and surcharge.
Partners also have to file their individual returns as per the tax slab they fall into. As above, however, all partners are jointly liable for any claims against partnership.
Limited Liability Partnership (LLP)
An amalgamation of the partnership and the company as it combines the legal attributes of the partnership.
Taxed in exactly the same way as a normal partnership, with the same tax filing obligations.
The partner’s liability is restricted to their capital contributions to the partnership, like in a company. There is also an accounts filing obligation like with a company.
Limited Company – Private Limited & Public Limited
This is where we have a bit of distinction. A company has a personality that is separate from the individual who owns the company. The company is the entity that is party to contracts, the one that makes profits and you need to be aware that there are rules around how you as an individual extract money from the company for your own personal use.
A Limited company is set up as per The Indian companies Act 1956, further refined in Indian Companies Act 2013.
There are two types of companies: Private Limited Company and Public Limited Company.
A private limited company is owned and traded privately, can have up to 50 members maximum, need minimum 2 Directors and the minimum paid up capital is INR 1 Lakh. Also, the transfer of shared is restricted to the members of the company. A Public limited company is owned & traded publicly. It can have unlimited members but need minimum 3 members and 3 directors with a minimum paid up capital of Rs. 5 Lakh. The right to transfer shares is unlimited.
The company is subject to tax on its profits, it files a corporate tax return and pays tax.
There is often an additional layer of tax when money is extracted from the company (i.e of you pay yourself a dividend or a salary) but this extra tax is not due when the company reinvests money in its trade.
The individual owners of the company are only liable up to their capital contribution to the company (i.e. the amount they invest). This can make the company an attractive option from a legal perspective as it fences the company assets and keeps your personal assets safe (in most instances anyway).
How To Decide On The Business Structure
- Am I likely to make profits from the outset?
- How much of my profits will be reinvested for growth?
- What is the risk of being sued for business activities?
- What impact will the choice of my business structure have on customer’s perception?
- How will my financial projections be taxed, how best could I use losses?
- Can I deal with the admin myself, or how much professional help will cost?
Once you’ve thought about the above, book a session with an expert and talk through your plans to get their professional advice on the right business structure.
Getting things right at the outset can mean you have better cash flow position, financial risks are limited and you are telling the right story to your future customers.
About The Author
[The author of this post is James Caan CBE- serial entrepreneur, CEO of Hamilton Bradshaw Private Equity.]