Guide to Choose a Business Structure

Selection of the form of business entity is one of the most important decisions before starting a business. This decision is required to be revisited periodically as the business develops. A business entity may exercise the options for conversion and re-conversion, as and when it seems appropriate. A business legal structure, also known as a business entity, is a government classification that regulates certain aspects of your business.

The choice amongst the various forms of business entities depends upon many aspects such as:

• objects of the proposed business,
• likely number of members,
• amount to be invested,
• scale of operations,
• government control
• legal requirements,
• tax implications,
• advantages of one form of business over another, etc.

Choosing the right business structure is a necessary part of running a business. Whether you're just starting out or your business is growing, it's crucial to understand the following:

• Your business’s legal structure determines your tax rates, management and paperwork requirements, fundraising abilities, and more.
• Sole proprietorships and partnerships are relatively easy to start, but they lack liability protection.
• Corporations may take more work to start, but they offer liability protection and, in some cases, more favorable tax rates.

Business enterprises can be broadly divided into two broad categories, namely, one which is non-corporate in form and the other which has a corporate character. Enterprises which fall in the former category are sole proprietorship, partnership and Hindu Undivided Family. Business organizations which comprise the latter category, are companies and co-operative undertakings. The basic difference between the corporate and the non-corporate form of organization is that while a non-corporate form of business may be started without registration, corporate bodies cannot be set up without registration under the laws which govern their functioning.

Non-Corporate Business Entities:

Non-corporate form of business entities can be started without registration; the following forms of business entities are called non-corporate business entities:

• Sole Proprietorship
• Joint Hindu Family/Hindu Undivided Family
• Partnership Firm

Corporate Business Entities:

Corporate form of business entities cannot be started without registration; the following forms of business entities are called corporate business entities:

• Company
• Limited Liability Partnership (LLP)
• Co-operative Organization

In this form of business organization, an individual normally uses his own capital, skill and intelligence to carry out some business activity. He is entitled to receive all the profits and gains of his business and also assumes all the risk of ownership. The sole proprietor exercises full control over the affairs of his business. As there is no legal obligation to supply any information regarding his business to anyone, he can maintain maximum secrecy in conducting his business affairs.

This type of organization is particularly suitable for businesses which are small in size and where risk and capital involved are not very large.

In this form of business ownership, the business is generally managed by the father or some other senior member of the family called the Karta or the manager. ‘Karta’ is basically the senior most male member of the family. The joint Hindu family firm comes into existence by the operation of Hindu Law and not by any contract.

This type of organization is particularly suitable for Hindu Undivided Families.

In this form of organization, few like-minded persons pool up their resources to form a partnership firm. Section 4 of the Partnership Act, 1932, defines partnership as “The relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all”. The following are the features of Partnership Firm.

1. Contractual Relationship: Since partnership arises out of agreement between persons, only those persons who are competent to contract can be partners.
2. Existence of business: There can be no partnership without business. The persons who have agreed to become partners must carry out some business activity.
3. Sharing of profits: The agreement to carry on business must be entered into, with the object of making a profit and sharing it among all the partners.
4. Mutual agency: The business must be carried on by all the partners or by any one or more of them acting for all the partners. Thus each partner is both an agent and a principal for all other partners.

Partnership is an ideal form of organization for medium scale business operations which require greater amount of capital and risks than sole proprietorship or Hindu Undivided Family.

It is a best option for Small businesses on sharing of profits between the Partners of the Firm.

This type of organization is characterized by the fact that ownership and management are separate. The capital of the company is provided by a group of people called shareholders who entrust the management of the company in the hands of persons known as the Board of directors. A company is an artificial legal person created by process of law which makes it an entity separate and distinct from its members who constitute it. As a natural consequence of incorporation and transferability of shares, the company has perpetual succession. Thus, it can be said that this form of organization is suitable when the capital requirements of a business are large, the liability of members is expected to be limited and the risks need to be spread among a larger number of persons.

If you have a long term growth and expansion plans, then the Company type of business entity is the best option for you.

LLP is an alternative business vehicle that gives the benefits of limited liability company and flexibility of a partnership firm. Since, LLP contains elements of both ‘a corporate structure’ as well as ‘partnership firm structure’; it is many a times termed as a hybrid of a company and a partnership. LLP is a separate legal entity which can continue its existence irrespective of changes in its partners. LLP is an incorporated partnership formed and registered under the Limited Liability Partnership Act, 2008.

LLP is useful for small and medium enterprises, in general, and for the enterprises in services sector, in particular. LLP is also very suitable for professionals like company secretaries, chartered accountants, cost accountants, advocates etc. as it helps them to form multi-disciplinary limited liability partnership firms.

Co-operative organization is a voluntary association with unrestricted membership and collectively owned funds, organized on democratic principle of equality by persons of moderate means and incomes, who join together to supply their needs and wants through mutual action, in which the motive of production and distribution is service rather than profit. Besides being a form of ownership co-operative organizations are a means of protecting the interests of the relatively weaker sections of society against exploitation by big businesses operating for the maximization of profits.

The basic feature which differentiates the co-operative organization from other form of business enterprises is that its primary motive is service to the members rather than making profits. A co-operative society is required to be registered under the Co-operative Societies Act, 1912. The co-operative societies receive a number of special concessions from the law and the Government, in order to encourage healthy development of Co-operatives.

A Co-operative society is an autonomous association of persons united voluntarily to meet their common economic, social, and cultural needs and aspirations through a jointly-owned and democratically-controlled enterprise. It is a voluntary association of persons whose motive is the welfare of the members; it protects the interests of the weaker section. The membership is voluntary. A person is free to join a cooperative society, and can also leave anytime as per his desire. Irrespective of their religion, gender & caste, membership is open to all.

Though it is a separate legal entity, the registration is compulsory. The liability of members is limited to the extent of amount contributed by them. The cooperative society works on the principle of mutual help & welfare. Hence, the principal of service dominates it’s working. If any surplus is generated, it is distributed amongst the members as a dividend in conformity with the bye-laws of the society. The main purpose of a Co-operative Society is to provide service to its members. For example, in a Consumer Co- Operative Store, goods are sold to its members at a reasonable price by retaining a small margin of profit. It also provides better quality goods to its members and the general public.

A cooperative (co-op) is owned by the same people it serves. Its offerings benefit the company’s members, also called user-owners, who vote on the organization’s mission and direction and share profits.

For new businesses that could fall into two or more of these categories, it’s not always easy to decide which structure to choose. Consider your startup’s financial needs, risk and ability to grow. It can be challenging to switch your legal structure after registering your business, so give it careful analysis in the early stages of forming your business. The following are the factors to consider as you choose your business structure:

• 1

  Flexibility

  Where is your company headed, and which type of legal structure allows for the growth you envision? Turn to your business plan to review your goals and see which structure best aligns with those objectives. Your entity should support the possibility for growth and change, not hold it back from its potential.

• 2

  Complexity

  When it comes to startup and operational complexity, nothing is more straightforward than a sole proprietorship. Register your name, start doing business, report the profits and pay taxes on it as personal income. However, it can be difficult to procure outside funding. Partnerships, on the other hand, require a signed agreement to define the roles and percentages of profits. Companies and LLPs have various reporting requirements with state governments and the central government.

• 3

  Liability

  A company carries the least amount of personal liability since the law holds that it is its own entity. This means creditors and customers can sue the company, but they can’t gain access to any personal assets of the directors or shareholders. A Company offers the same protection but with the tax benefits of a sole proprietorship. Partnerships share the liability between the partners as defined by their partnership agreement.

• 4

  Taxes

  A company files its own tax returns each year, paying taxes on profits after expenses, including payroll. If you pay yourself from the company, you will pay personal taxes, such as those for Social Security and Medicare, on your personal return.

• 5

  Control

  If you want sole or primary control of the business and its activities, a sole proprietorship might be the best choice. You can negotiate such control in a partnership agreement as well.

• 6

  Capital Investment

  If you need to obtain outside funding from an investor, venture capitalist or bank, you may be better off establishing a company.

• 7

  Registration & Licenses

  In addition to legally registering your business entity, you may need specific licenses and permits to operate. Depending on the type of business and its activities, it may need to be licensed at the local, state and central levels. The formation of Proprietorship and Partnership Firms are cheaper than companies and LLPs.