Choosing the Right Legal Form for Your Startup

By Guest Author|1st Jul 2012
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An entrepreneur is always in a dilemma, as to which legal form should he choose for his start-up – whether it should be a sole proprietorship, partnership, private limited company, public limited company, trust etc.

There are no hard and fast rules to choose any legal form. An entrepreneur has to pose the following questions to himself and based on the answers to the questions below, he can make a self-assessment of which option to consider.

1.     Is the idea a profit making one?

If the idea is a non-profit making one, then, it is advisable to float a charitable trust and obtain income tax exemption for the same.

But, if the idea involved is a profit making one, then there are a couple of more questions to arrive at an informed decision.

2.   Do you require liability protection for your personal assets?

This is the most important question and it means that, if the enterprise ends up in a loss, would you be fine with utilizing your personal assets to clear off the debts incurred?

If the answer is yes, options of floating it as a sole proprietorship / partnership concern can be considered.

But, if you are not fine with utilization of personal assets, it is advisable to either consider limited liability partnership / private limited company / public limited company.

3.   How many promoters are going to be part of the start-up?

This characteristic will play an important role in deciding the legal form as there are number restrictions for each legal form.

Legal formMinimumMaximum
Sole Proprietorship11
Partnership220
Limited liability partnership (LLP)2Unlimited
Private Limited Company250
Public Limited Company7Unlimited

4.   Are any restrictions to be imposed on transfer of ownership to any other person?

A Public limited company does not pose any restriction for transfer of ownership from one person to another.

Whereas a private limited company does not allow shareholders to freely transfer their ownership in the company to any outsider.

In a partnership/limited liability partnership, the partnership deed needs to be changed to admit a new partner or to transfer the rights to a new partner. Each such change needs the concurrence of all partners thus restricting free admission/transfer.

5.   How much capital is available initially?

The following table illustrates the minimum capital required (statutorily) to set-up an entity under each legal form:

Legal form

Minimum capital contribution required

Sole Proprietorship/Partnership/LLP

Nil

Private limited company

100,000

Public limited company

500,000

In addition to the above, there are additional setting-up expenses such as charges to be paid to consultants, fees to government etc (which can quantified only on a case to case basis).

6.   How quickly do you want to kick start operations?

There is a minimum time frame required to set-up the organization based on its legal form.

Legal form

Approximate setting up time

Sole Proprietorship/Partnership

1 – 4 days

LLP/Private Limited Company/Public Limited Company

7 – 30 days

The time frame mentioned above is only suggestive. It can vary depending on other factors. It is better to match the time you have in hand to kick-start the operations with the approx. setting-up time required and then conclude on the option.

7.   What are the tax implications of profits in the hands of the start-up and also in the hand of owners?

Legal formTaxation of profits (in the hands of the entity)Taxation of profit/dividends/ salary in the hands of ownersRestriction on distribution of profits to owners (as per Income tax act)
Sole ProprietorshipNYN
Partnership / LLPNYY
Private / Public Limited CompanyY – Both Income tax and dividend distribution tax has to be paid.NN

8.   What are the future funding / expansion requirements?

If one anticipates funding requirements immediately, then it is better to float it as a private/public limited company. This makes it easier for offering stake to a funding partner.

Conclusion

Thus, the choice needs to be made keeping all the above things in mind. To conclude, this is one of the first decisions to be taken by an entrepreneur and if done intelligently, ensures a smooth transition and avoids many a hardship in the future.

About the author

Praveen S Krishnan founded Innosolv Consultancy Services, which is engaged in providing financial, regulatory, legal and process consultancy for start-ups. He heads the Bangalore practice for R. Rajan Associates, a Chartered Accountancy firm.

Source: YourStory.in

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