One of the most critical decisions you will face as a business owner is whether to incorporate (i.e. form a private limited company) or to operate your small business as a proprietor. You should consider three aspects before answering this question:
- Number of stakeholders.
- At what stage is your business? What are your long term objectives and goals?
- Tax Consequences.
Number of Stakeholders
Naturally, if you have a partner or others who are running the business with you, then proprietorship is not an option for you. You must either incorporate or register as a partnership firm.
Consider whether you want to take the entire work load on yourself or would you rather promote others to join you? Are you paying salary to your staff? Do you have potential suitors to help you expand?
For scalable businesses, it is a much better idea to find equal partners than trying to run everything yourself. For example – while it may make more sense for a legal consultant to operate standalone, he would be better advised to expand before he gets into legal services as the latter would require a larger team.
Stage of Business
Operate as a Proprietor
Easy to Start up: Proprietorships are easy to start, easy to close and there are very few regulatory requirements. All you need is a registration certificate from the department of labour to become a business owner.
Note: Many firms operate without a registration document which is not advisable. It is easy to procure this document from the department of labour. These days for most states, the registration is free of cost and you can do it online by filling a form. See example here (for Delhi).
Credibility: that said, the biggest challenge which individual proprietors face is lack of credibility when doing business. It is difficult to get loan approvals, negotiating with private equity funds and selling the business in part or full. Banks in particular worry that a proprietorship will end with the proprietor and it will be hard for them to recover their dues.
Tip: While you can operate a proprietorship in your own name, it is a better idea to have a trade name in which you register your proprietorship firm.
Firm Name – Sana Securities | Proprietor – Rajat Sharma
This helps in 2 ways:
First, branding adds a certain level of credibility to a business. It’s all psychology really. People are a lot more comfortable doing business with a brand than with a person. As businessmen, you should do exactly the opposite but let’s leave that for another day.
Second, while you conduct regular business you are also creating brand value for a potentially larger business in future. Think of it as baby steps towards incorporation. Further, don’t forget that often a brand becomes so big that it gets sold out even in the absence of a concrete business behind it.
What’s in a brand? – The Kingfisher debacle
For all practical purposes, Kingfisher Airlines is bankrupt company. Nevertheless, ‘Kingfisher’ brand, under which both i.e. the airlines and beer business operates enjoys a high brand value. The consortium of banks which extended credit to Kingfisher Airlines has an outstanding of more than Rs. 7,000 Cr owed to them by Kingfisher Airlines. The total collaterals including shares of other group entities such as United Spirits was valued at approximately Rs. 500 Cr. (on February 14th 2013). State Bank of India claimed that they have the brand ‘Kingfisher’ as security for this outstanding amount, a claim fiercely disputed by United Breweries Limited (“UBL”), the owner of brand Kingfisher.
It is unlikely that any other airline company would pay to buy the ‘Kingfisher’ brand to run an airline company. Assuming (hypothetically) that Kingfisher brand was up for sale, would you think that the consortium of banks will find prospective buyers? May be other companies in the liquor industry?
Stage of Business
If there is one lesson you learn from this article, make it this one – Don’t sit on that idea – Just start! I see far too many people spend years perfecting an idea or being unsure about the right time to start.
Things to do at the set up stage:
- Get your trade name registered
- Open bank account
- Set up a website
- Start holding client conferences
- Get customer feedback – use questionnaires
Tip: You don’t have to quit your job to do any of this. Start working over weekends. I recommend that you give yourself at least 6 months before giving up on your job, after you start with these activities.
If you are operating independently, there is little reason for you to incorporate a company. In almost all situations, you should start as a proprietor. Forming a company is expensive and has little benefit.
Why You Should Avoid Forming a Company
- It is expensive: You will need to hire an agent, typically a company secretary to do the necessary paperwork. In addition, there are incorporation fees depending upon the authorised capital that you wish to start with.
- Compliance: A company has to hold an Annual General Meeting (AGM), pays flat income tax of 30% on any income it makes and must get its accounts audited from a chartered accountant, annually. Your income from proprietary business is clubbed with your individual income. Accordingly, you pay a lower rate of tax depending upon your tax slab.
- It’s pointless: As a start up, your focus should be cutting down expenses to the extent possible. Incorporation has little benefit for individual business owners. Most young business owners incorporate as a feel good factor hoping that this alone will add much credibility to their venture; what it does in reality is burden them with useless compliance and regulatory requirements.
Once your business matures, you should change from a sole proprietorship to a company. Maturity here has no definition. It need not necessarily be when you start making profits.
Advantages of Forming a Company
- Operating with Partners: If you are running the business in conjunction with others, it is best to divide shareholding from the very beginning. Avoid getting into informal arrangements, they invariably run into troubles.
- Planning to raise funds: If you are planning to raise money for your business, particularly private equity funding, then you will have to register as a company and issue shares in return for funding.
Also Read: Raising Equity Capital in India
- Planning to list on a stock exchange: If you are planning to list your business on a stock exchange and raise money from the market, you must have an operating history of at least 3 years before you file your offer document with the exchange. Plenty of reforms are being planned in this area for young start up businesses including doing away with the requirement with regard to 3 year operating history.
- Limiting Your Liability: By creating a company, you can limit your liabilities, i.e. you will not be liable for the debts and obligations of the company. As a proprietor, you have unlimited liability for all debts and obligations of the company. This means that your personal assets can be attached to recover dues owed by your business.
Proprietorship: Your income and expenses as a proprietor are clubbed with your individual income and expenses. Similar pass through effect applies in case of partnerships. The advantage is that you will get full benefit of exemption limits based on the income tax slab to which you belong.
For example, as an individual below the age of 60 you pay only Rs. 1, 25,000/- income tax for your income up to Rs. 10,00,000/- (and a higher rate of 30% for income above Rs. 10,00,000/-). You will also be able to get the benefit of all rebates applicable to individuals.
Note: The fact that your proprietor business operates under a separate trade name makes no difference in the above mentioned tax treatment.
Company: A registered company pays a flat income tax of 30% on all its income. No exemptions apply in case of companies.
Selling Your Start up Business: Treatment of Capital Gains – Sale of Private Limited Companies’ Shares
If your intention is to sell your business after a few months/ years, once it reaches a certain level of maturity then you should give due consideration to the treatment of capital gains. Consider the example below:
Rajat Sharma, a first generation entrepreneur starts a finance education website – www.sanasecurities.com In 3 years, the website is a runaway success and after 3 years, Rajat gets an offer to sell his website to ABC Print Limited in a deal valued at Rs. 5 Cr. Rajat decides to sell and joins ABP Print as their CEO.
The tax treatment of Rs. 5 Cr. In the hands of Rajat will differ depending upon the structure of the firm which owns the portal – www.sanasecurities.com .
If Rajat operated the firm as a proprietor, then Rs. 5 Cr. which he receives upon its sale will be treated as income in his hands taxable according to his tax slab (i.e. @ 30% for the amount exceeding Rs. 10, 00,000).
Tax liability = Rs. 1,48,25,000 (Rs. 1,25,000 on income up to Rs. 10,00,000 and Rs. 1,47,00,000 on balance Rs. 4,90,00,000).
If Rajat had incorporated his firm, and held shares for over 36 months, then Rs. 5 Cr. which he receives upon sale will be considered Long Term Capital Gain* in his hands and will be eligible for a concessional rate of tax at 20%.
* Shares held in unlisted companies are considered long term capital assets if held for more than 36 months.
Tax liability = Rs. 1,00,00,000.
By incorporation Rajat saved Rs. 48,25,000.
Many accountants persuade business owners to incorporate based on a rather flawed view is that it is easier to show higher expenses on the books of a company than in proprietary business, thereby reducing your taxable income. I neither subscribe to this view nor do I think that there is any merit in that. On the contrary, I believe it is far easier to manage proprietary business accounts.