Exploring Legal Considerations When Choosing A Business Entity

From conceptualizing a business plan to bringing it into reality, it takes immense time, planning, and effort, making it a turbulent task for a person with limited resources or knowledge to start a business venture. And choosing the right type of business entity will lay a sound foundation for running the business and achieving the desired objectives in the long run. Therefore, choosing the appropriate business entity—whether it be a sole proprietorship, partnership, company, or another type—is essential. Several factors should be taken into account when making this decision, including ownership, tax implications, investments, the method of transferring ownership, intellectual property, and others. These factors will be covered in more detail in the sections that follow with regard to a particular type of business entity.

1. SOLE PROPRIETORSHIP-

The simplest form of business entity is a sole proprietorship, where ownership rests with a single person, and accordingly, the liabilities accrue to the owner personally, making the business come to an end with the death of the sole proprietor. In other words, the business is not a separate legal entity from that of the owner; it has an unlimited business liability, and it can sue or be sued in the name of the sole proprietor.

As such, there is no need to register a sole proprietorship in India. However, the proprietor has to take into account the below:

Registration Requirements:

1. No need to register a sole proprietorship in India.
2. Obtain GST (Goods and Services Tax) registration.
3. Obtain UDYAM registration.
4. Register under the Shops and Establishment Act.
5. Open a current bank account.
6. Proprietor’s PAN (Permanent Account Number) and Aadhar cards are required.
7. Additional Legal Requirements and Licensing:

Additional Legal Requirements and Licensing:

1. Obtain an FSSAI (Food Safety and Standards Authority of India) license if applicable.
2. Obtain a local trade license if applicable.
3. Additional requirements and licensing may vary based on the nature of the business, state, industry, and local regulations.

Taxation:

1. Sole proprietor files income tax return in form ITR-3 or ITR-4.
2. Income tax rate for sole proprietorship businesses is the same as the individual rate.
3. Tax deducted at source (TDS) for businesses with employees or significant purchases.
4. TDS returns must be filed every quarter.

Thus, with minimal legal compliances, fee requisites, and the free decision-making authority of the owner, a sole proprietorship is the go-to business entity to conceptualize a small-scale business plan of an individual.

2. PARTNERSHIP FIRM-

With a minimum of two persons, a partnership firm can be constituted by simply entering into an agreement known as a partnership deed and dividing the profits and losses among its members. In India, the Partnership Act of 1932 governs the registration and other legal aspects of partnerships. Registration under the Act is not mandatory yet recommended to reap certain legal benefits, such as the right to sue other partners or the firm itself in case of breach of contract. Secondly, only a registered partnership firm can sue a third party, whereas any person can sue the firm, whether registered or not. Thirdly, only a registered firm can claim set-off or enforce any right arising from any legal proceedings.

Though general partnership firms have unlimited liability, there are also limited liability partnerships where the liabilities of each partner are limited according to the agreed contribution to the business.

Partnership Firm Income Tax Return:

1. Partnership firm files income tax return on Form ITR-5.
2. Partnership income tax return is used instead of individual income tax returns for the partners.

Tax Payment and Individual Tax Liability:

1. Once the tax is paid by the partnership firm, partners do not have to pay tax from their share of income.
2. The amount of interest or remuneration received by the partner will be taxed in their hands as business or professional income.
3. Partners’ individual tax liability is separate from the firm’s tax liability.

Exclusion of Disallowed Amount:

The amount disallowed at the hands of the firm will not be taxed in the partners’ hands.

3. COOPERATIVE-

Another type of business entity is a cooperative, which is a legally incorporated body that serves the interests of its members. It can be in all sectors and be on a profit-sharing or non-profit-sharing basis. Forming a cooperative can be rightly described as an excellent way to minimize financial risk. Being a fundamental right to form a co-operative, a co-operative registered under the Co-operative Societies Act, 1912, is considered a separate legal entity by law. The functioning of the same is also governed by the State Co-operative Societies Act and the Multi-State Co-operative Societies Act, of 2002. The Income Tax Act of 1961 recognizes cooperative societies as separate entity falling under the category of assessee. Accordingly, there are certain exemptions and specified deductions from the gross total income available to the cooperative societies.

4. COMPANY-

An association of two or more persons in furtherance of a common objective, otherwise known as a “company,” is a separate legal entity and one of the most common types of business entities in India. It needs to be mandatorily registered under the Companies Act, and the companies can be divided into several entities based on the number of members, the limit of liability, control or holding, access to capital, and other factors. There are even limited liability companies that protect their members from personal liabilities or debts. Each such entity has different legal requirements for formation and registration, tax implications, IP requirements, and other legal compliances depending on the type of company.

Registering as a Private Limited Company in India brings a host of benefits that contribute to its appeal, such as limited liability protection, enhanced credibility, access to funding opportunities, favorable tax benefits, and flexibility for business expansion.

Limited Liability: Shareholders’ liability is limited to the extent of their shares in the company, protecting personal assets from business liabilities.

Separate Legal Entity: The Company is considered a separate legal entity distinct from its shareholders, providing a clear distinction between personal and business assets.

Credibility and Perpetual Existence: A registered private limited company enjoys increased credibility among stakeholders such as customers, suppliers, and financial institutions. The company has perpetual existence, meaning it can continue its operations even if the shareholders change.

Access to Funding: Private limited companies can attract investments from venture capitalists, angel investors, and other institutions more easily compared to other business structures. Issuing equity shares allows for raising capital and expanding the business.

Transferability of Ownership: Shares in a private limited company can be easily transferred or sold to new shareholders, facilitating ownership changes and exit strategies.

Tax Benefits: Private limited companies are eligible for various tax deductions, exemptions, and incentives provided by the government. Corporate tax rates for private limited companies may be lower than individual income tax rates.

Employee Benefits: Private limited companies can offer attractive employee benefits, including stock options, employee stock ownership plans (ESOPs), and other incentives to attract and retain talent.

Statutory Compliance: While private limited companies have compliance requirements, they generally have less extensive compliance obligations compared to public limited companies.

Limited Regulatory Control: Private limited companies have comparatively less regulatory control and reporting requirements compared to listed public companies.

Business Expansion: Private limited companies have greater flexibility for business expansion, including opening branches, forming subsidiaries, and entering into contracts in the company’s name.

There are several legal factors to be considered while deciding on the type of business entity. As stated above, each type of business entity requires different legal compliances, investment requirements, and costs and has different tax implications, including specific or general exemptions or deductions. Among all these factors, intellectual property rights are one of the major considerations for choosing a business entity. Even the cost of filing IP is different for different business entities. For example, the cost of filing a trademark application in one class for an MSME, sole proprietorship, or start-up is Rs. 4,500, whereas for a company it is Rs. 9,000. Thus, each of these considerations must be examined in light of the primary goal of managing a business venture that would successfully build a firm’s foundation for years to come.

Vedant Pujari, Partner

Ritika Reddy, Senior Associate