There are various forms of business organizations. The selection of the most suitable form of business organization is a very crucial decision because each form of organization has its own merits and demerits. Therefore, it is very important to consider these merits and demerits before selecting the form of business organization.
For a new or proposed business, the selection of a suitable form of a business organization is generally governed by the following factors:
Nature of business activity
This is an important factor having a direct bearing on the choice of a form of ownership. In small trading businesses, professions, and rendering of personal services, sole-proprietorship is predominant.
Examples are Laundromats, beauty parlors, repair shops, consulting agencies, small retail stores, medicine stores, dentists, accounting concerns, boarding-house, restaurants, specialty ship, jobbing builders, painters, decorators, bakers, confectioners, tailoring shops, small scale shoe repairers, and manufacturers, etc.
The partnership is suitable in all those cases where sole proprietorship is suitable, provided the business is to be carried out on a slightly bigger scale with help of one or more partners (owner).
Besides, the partnership is also advantageous in the case of manufacturing activities on a modest scale. The finance, trading, and real estate industries (on a smaller scale) seem to be suited to partnership forms of organization. Some of the financial businesses that find this form advantageous are tax, accounting, stock brokerage firms, consulting agencies, etc.
Service enterprises like hotels and lodging places; trading enterprises, such as wholesale trade, retail houses; small-scale manufacturing enterprises, small drug manufacturers, etc. can be undertaken in the form of partnership. Similarly, the business lines such as carrying on large chain stores, multiple shops, super-bazaars, engineering industrial activities with high capital and working capital requirements, and software industrial activities are generally in the form of companies.
Where the persons intending to start a business wish to launch a business organization clothed with a legal entity and in-corporate form with a feature of having their sole ownership and control thereon, they may decide to form a One-Person Company (OPC). OPC is a new concept in India and hybrid of Sole-Proprietor and Company form of business. The concept opens spectacular possibilities for sole proprietors and entrepreneurs as, such companies retain the character of a Sole Proprietorship, provides limited liability feature to the sole proprietor, and is clothed with a legal entity distinct from its owner.
An alternative form of organization where two or more persons are involved in starting the business organization is the Limited Liability Partnership (‘LLP’) under the Limited Liability Partnership Act, 2008. Such entities have also gained popularity nowadays. A major advantage of such an entity is that the liabilities (if any), of the LLP, lies with the entity and does not fall on the individual partners unlike the partnership form of business organization under the Indian Partnership Act, 1932, where the joint and several liabilities of the partner(s) is one of the features.
In an LLP form, the liability of the Partner is limited to the extent of his contribution towards the LLP, except in the case of intentional fraud or wrongful act of omission or commission by the partner himself. What is at stake for the partner is what he has put into the business along with any personal guarantees he would have furnished. However, such forms of business organization are suitable generally in the service industry and where there is no dependence on large amounts of financing from outside sources.
A One-Person Company (OPC), LLP, and limited company exist as a separate business entity in the eyes of law and this creates a wall between the personal assets of the investor and that of the business. Thus, in these forms of business organizations, the personal property of the owner(s) is protected and this gives the owner(s) the ability to build the business credit, get loans and raise capital
Scale of operations
The second factor that affects the form of business organization is the scale of operations. If the scale of operations of business activities is small, sole proprietorship or a One Person Company (OPC) is suitable; if the scale of operations is modest — neither too small nor too large — partnership or limited liability partnership (LLP) is preferable; whereas, in case of the large scale of operations, the company form is advantageous The scale of business operations depends upon the size of the market area served, which, in turn, depends upon the size of demand for goods and services. If the market area is small, local, sole-proprietorship, OPC, or partnership opts. If the demand originates from a large area, a partnership including LLP or Company may be adopted.
Capital is one of the most crucial factors affecting the choice of a particular form of ownership organization. The requirement of capital is closely related to the type of business and scale of operations. Enterprises requiring heavy investment (like iron and steel plants, large-scale infrastructure projects, etc.) should be organized as companies. Depending on the capital required, they can be set up as public companies and in some cases, maybe in the form of listed companies by raising money from the public and being listed on the stock exchanges.
Enterprises requiring small investment (like retail business stores, personal service enterprises, etc.) can be best organized as sole proprietorships or even as Partnerships. Apart from the initial capital required to start a business, the future capital requirements—to meet modernization, expansion, and diversification plans —also affect the choice of form of organization.
In a sole proprietorship, the owner may raise additional capital by borrowing, by purchasing on credit, and by investing additional amounts himself. Banks and suppliers, however, will look closely at the proprietor’s individual financial resources before sanctioning any loans or advances.
Partnerships can often raise funds with greater ease since the resources and credit of all partners are combined in a single enterprise. Companies are usually best able to attract capital because investors are assured that their liability will be limited, their operations are in the public domain in a transparent manner, easily accessible and the ownership can be transferred to other investors.
It is difficult for a sole proprietor to have expertise in all functional areas of business. Further, the size of the business may not permit the engagement of professional management.
In other forms of organizations like partnership and company, there is a division of work among the partners which allows the partners to specialize in specific areas, leading to better outputs and decision making. However, this may sometimes lead to conflicts due to differences of opinion. The company form of organization is a better alternative if the operations are far-flung, complex in nature, and require professional management at various levels.
Degree of control and management
The degree of control and management that an entrepreneur desires to have over business affects the choice of form of organization. In Sole proprietorship and OPC, ownership, management, and control are completely fused, and therefore, an entrepreneur has complete control over his business. In partnership, management and control of business is jointly shared by the partners, and their specific rights, duties, and responsibilities would be documented through incorporating various clauses in this regard in the partnership deed.
They have an equal voice in the management of partnership business except where they agree to divide among themselves the business responsibilities in a different manner. Even then, they are legally accountable to each other. In a company, however, there is a divergence between ownership and management, the management and control of the company business is entrusted to the Board, who are generally the elected representatives of shareholders.
Thus, a person wishing to have complete and direct control of business prefers a proprietary organization rather than a partnership or company. If he is prepared to share it with others, he will choose partnership. But, if the activities are large, professional managers are required to handle the day-to-day affairs and there is a need for corporate structure and management, he will prefer the company form of organization.
Degree of risk and liability
The size of risk and the willingness of owners to bear it is an important consideration in the selection of a form of business organization. The amount of risk involved in a business depends, among other factors, on the nature and size of the business. Smaller the size of the business, the smaller the amount of risk.
Thus, a sole proprietary business carries a small amount of risk with it as compared to a partnership or company. However, the sole proprietor is personally liable for all the debts of the business to the extent of his entire property. Likewise, in partnership, partners are individually and jointly responsible for the liabilities of the partnership firm.
Companies and LLPs have a real advantage, as far as the risk is concerned, over the other forms of business organization. Creditors can force payment of their claims only to the limit of the company’s and LLPs assets. Thus, while a shareholder/member/partner may lose the entire money he puts into or agreed to put into the company and LLP, he cannot be forced to contribute additional funds out of his own pocket to satisfy the business debts of the company and LLP.
Stability of business
The stability of the business is another factor that governs the choice of an ownership organization. A stable business is preferred by the owners in so far as it helps him in attracting suppliers of capital who look for the safety of investment and regular return and also helps in getting competent workers and managers who look for the security of service and opportunities of advancement. From this point of view, sole proprietorships are not stable, although no time limit is placed on them by law.
The illness of the owner may derange the business and his death cause the demise of the business. Partnerships are also unstable since they are terminated by death, insolvency, insanity, retirement, admission, expulsion, or withdrawal of/ by one of the partners. Companies and LLPs have the most business stability due to their feature or perpetuity being an artificial or legal person. The life of the company and LLP is not dependent upon the life of its members/partners. Members/partners may come, members/partners may go, but the company/LLP goes on forever unless and until it is wound up.
Flexibility of administration
As far as possible, the form of organization chosen should allow flexibility of administration. The flexibility of administration is closely related to the internal organization of a business, i.e., the manner in which organizational activities are structured into departments, sections, and units with a clear definition of authority and responsibility.
The internal organization of a sole proprietary business, for instance, is very simple, and therefore, any change in its administration can be effected with the least inconvenience and loss. To the large extent, the case is the same in a partnership business also. While, in the case of a company, the administration is not that flexible because its activities are conducted on a large scale and are quite rigidly structured.
Any substantial change in the existing line of business activity — say from cotton textiles to sugar manufacturing — may not be permitted by law if such a provision is not made in the ‘objects clause’ of the Memorandum of Association of the company. Thus, from a flexibility point of view, sole proprietorship has a distinct edge over other forms.
Division of profit
Profit is the guiding force of private business and it has a tremendous influence on the selection of a particular form of business organization. An entrepreneur desiring to pocket all the profits of the business will naturally prefer sole proprietorship. Of course, in a sole proprietorship, the personal liability is also unlimited.
But, if he is willing to share the profits, a partnership form of organization would be preferred. In a company organization, however, the profits (whenever the Board of Directors decides) are distributed among shareholders in proportion to their shareholding, but the liability of the shareholders is also limited. The rate at which a dividend is to be distributed is decided by the Board, though approved by the shareholders. Companies may also reward shareholders by the issue of bonus shares. In the case of listed companies, the equity shares are tradeable on the stock exchanges, enabling the shareholders to exit the company at any time as per their own discretion.
Costs, procedure, and government regulation
This is also an important factor that should be taken into account while choosing a particular form of organization. Different forms of organization involve different procedures for the establishment and are governed by different laws which affect the immediate and long-term functioning of a business enterprise. From this point of view, sole proprietorships are the easiest and cheapest to get started. There is no government regulation. What is necessary is the technical competence and the business acumen of the owner and the requirement of meeting tax liabilities.
Partnerships are also quite simple to be initiated. Even a written document is not necessarily a prerequisite since an oral agreement can be equally effective. However, in actual practice, a written partnership deed is usually entered into, as it is needed for registration of the firm and for tax authorities. The procedure for dissolution of a partnership is also, relatively simple.
The company form of business organization is more complicated to form. It can be created by law, dissolved by law, and operate under the express provisions of the law. In the formation of a company, a number of legal formalities have to be gone through which entails, at times, quite a substantial amount of expenditure. Further, various formalities have to be complied with for the closure of companies. Non-payment of dues may land the company insolvency or liquidation.
For example, the cost incurred on the drafting of the Memorandum of Association, the Articles of Association, the Prospectus, issuing of share capital, etc. can be quite high. This cost is, however, small in the case of private companies. Besides, companies are subjected to a large number of anti-monopoly and other economic laws so that they do not hamper the public interest.
In the choice of the form of business organization, tax implication plays an important factor. In smaller entities, such as sole proprietorship or partnership, the tax liability is dependent on the extent of profits. However, the liability of the owner(s) is unlimited. In the case of companies or LLPs, the liability of shareholders is limited to the value of shares they have purchased. In the case of companies or LLPs, tax liability could be higher.
The applicable tax rates for different forms of business organization are summarised below:
(i) Sole Proprietorship
In case of sole proprietorship (where the age of the proprietor is less than 60 years), the income tax rates for assessment year 2019-20 is Nil for taxable income upto Rs.2,50,000, 5% for taxable income between Rs.2,50,000 to Rs.5,00,000, 20% for taxable income between Rs.5,00,000 to Rs.10,00,000 and 30% for taxable income above Rs.10,00,000.If the proprietor is between 60 years & 80 years, upto 300,000, income tax rate is Nil. If the proprietor is above 80 years of age, more tax concession is available , upto 5,00,000 , Income Tax if Nil.
(ii) Partnership firm
Partnership firms in India can be divided into two categories namely, registered partnership or unregistered partnership. Registered partnership firms are those firms having a registration certificate from the Registrar of Firms. All other partnerships that do not have a registration certificate would be classified as unregistered partnership firms.
Under Income Tax Act, a partnership firm is defined as “Persons who have entered into a partnership with one another are called individually “partners” and collectively “a firm”, and the name under which their business is carried on is called the “firm name”.
Partnership firms (including Limited Liability Partnership Firm) are liable to pay income tax at the rate of 30% of total income. In addition to the income tax, a partnership firm is liable to pay an income tax surcharge on the amount of income tax at the rate of 12%, when total income exceeds Rs. 1 crore. However, the surcharge shall be subject to marginal relief (where income exceeds one crore rupees, the total amount payable as income-tax and surcharge shall not exceed total amount payable as income-tax on total income of one crore rupees by more than the amount of income that exceeds one crore rupees).
In addition to the income tax and surcharge, a partnership firm must pay
- education cess at the rate of 2% on tax plus surcharge;
- secondary and higher education cess at the rate of 1% on tax plus surcharge.
- The above-mentioned cess is applicable on the amount of income tax and the applicable surcharge at the rate of 1%.
Similar to a private limited company or LLP, partnership firms are also required to pay alternate minimum tax at the rate of 18.5% of “adjusted total income”. Alternative minimum tax would be increased by the applicable surcharge, education cess, and secondary and higher education cess.
(iii) Domestic Company
Net Profit of a domestic company (including a Limited Liability Partnership to which the Income Tax rates for domestic companies is applicable) is taxable at 30%. However, the tax rate is 25% if turnover or gross receipt of the company in the previous year 2018-19 does not exceed 250 crores. In addition, there is:
- Surcharge at 7% of tax where total income exceeds Rs.1 crore and below Rs.10 Crores and 12% of tax where total income exceeds Rs.10 crores and
- Education Cess at 2% of tax plus surcharge
- Secondary and Higher Education Cess at 1% of income tax and surcharge.
(iv) Co-operative Society
The tax rate is 10% for taxable income upto Rs.10,000, 20% for taxable income between Rs.10,000 to Rs. 20,000 and 30% for taxable income above Rs.20,000. In addition, there is:
- Surcharge at 12% of tax where total income exceeds Rs. 1 crore; However, the surcharge shall be subject to marginal relief (where income exceeds one crore rupees, the total amount payable as income-tax and surcharge shall not exceed total amount payable as income-tax on total income of one crore rupees by more than the amount of income that exceeds one crore rupees).
- Education Cess at 2% of tax plus surcharge
- Secondary and Higher Education Cess at 1% of income tax and surcharge.
The extent to which the product or service is proposed to be manufactured or made available also plays a vital role in choosing the type of business organization. If a concern deals with a local market, a seasonal product, or perishable goods, or is meant to cater to a specific city or locality, then sole proprietorship or partnership form of business may be suitable. If it is proposed to market the product or service all over India (which may also entail providing customer support services), a company form of organization may be preferred
Transferability of ownership
Sole proprietorship, being a one-person entity does not lend itself to transferability of ownership as the owner himself enjoys the profits and suffers the losses in his business. A partnership form of the organization is one where two or more partners share the profits and/or losses in the agreed proportion. If a partner exits, the partnership, may decide to induct a new partner with benefits of ownership and share of profits or losses. In the company form of organization, transfer of ownership is possible by transfer of shareholding by any person or group of persons in favor of another person or group of persons.
Managerial and administrative requirements also affect the decision about the form of the organization. When the concern is small and it caters to local needs only then one person will be enough to manage the business. The sole – proprietorship form of organization will be suitable for such a business. If business caters to more areas, then more persons will be needed to look after various business functions in various areas. When a business is run on a large–scale basis, it will require the services of specialists to manage various departments. The company form of organization will be suitable for such concerns.
Secrecy is of supreme importance, particularly in small business concerns. Accordingly, the entrepreneur would select the sole proprietorship for that reason. In case, he has partners, he will have to carefully weigh whether other partners will be able to maintain the secrecy. He will have to exercise great care in taking partners.
In the case of a company, secrecy may be restricted to the manufacturing process or the manner in which business is conducted. However, certain aspects of their business such as their board of directors, shareholding, financial statements, and other information which are statutorily required to be placed in the public domain are accessible to any person.
The company is subject to strict government regulations. So, if the entrepreneur wants to have freedom in business with little governmental interference, he has to go for either sole proprietorship or partnership
The consideration of the various factors listed above clearly shows that:
- These factors do not exist in isolation but are interdependent, and all these factors are important in their own right. Nevertheless, the factors of nature of business and scale of operations are the most basic ones in the selection of a form of ownership for setting up a business organization. All other factors are dependent on these basic considerations. For instance, the financial requirements of a business will depend on the nature of the business and the scale of operations planning. To take an example, if a business wants to set up a trading enterprise (say, a retail store) on a small scale, its financial requirements will be small.
- The various factors listed above are only major factors, and in no case do they constitute an exhaustive list. Depending upon the requirements of the business, the demands of the situation, and sometimes even the personal preference of the owner, the choice of a form of ownership is made.
- The problem in choosing the best form of business organization is one of analyzing and weighing relative advantages and disadvantages to find the one that will yield the highest net advantage. And for that, weights may be assigned to different factors depending upon their importance in each form of organization, and the type of organization that obtains the maximum weights may be ultimately selected.