A business can be organised in several ways, and the form it's owners chose will affect the company's and owner's legal liability and income tax treatment.
Here are the most common options and their major defining characteristics.
This is generally the simplest way to set up a business. Sole Proprietorship is a businesses owned by a single person, the sole proprietor. In a sole proprietorship all profits, losses, assets, and liabilities are direct and sole responsibility of the owner. A sole proprietor is fully responsible for all debts and obligations related to his or her business. A creditor with a claim against the business, would normally have the right against all of the owner's assets, whether business or personal. This is known as Unlimited Liability.
Sole proprietorship are not ideal for high risk businesses because they put all your personal assets at risk. If one is taking a significant amount of debt to start a business, if he has gotten into trouble with personal debt in the past or if the business involves an activity for which the owner might potentially be sued, then he should choose a legal structure that will better protect his personal assets.
Advantages of Sole Proprietorship
Easiest and least expensive form of ownership to organise.
Low Start-up costs. Minimum working capital required.
Sole Proprietors are in complete control, and within the parameters of the law can make any decision regarding the business as they feel fit.
Less administrative paperwork than some other organisational structures.
Profits and tax advantages can be availed directly by the owner.
Profits from the business flow through directly to the owner's personal tax return.
The business is easy to dissolve, if desired.
Disadvantages of Sole Proprietorship
Sole proprietors have unlimited liability, and are legally responsible for all debts against the business. Their business and personal assets are at risk.
Difficulty in raising funds and are often limited to using funds from personal savings or consumer loans.
Difficult to continue the business in the absence of the owner.
A partnership is an agreement in which two or more persons combine their resources in a business with view of making profits. In a partnership, two or more persons share ownership of a single business.
In order to establish the terms of the business, and to protect partners / shareholders in the event of disagreements or dissolution of the business, a partnership / shareholders agreement should be drawn up, usually with the help of a lawyer.
The partners should have a legal agreement that sets forth how decision will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, or what steps will be taken to dissolve the partnership when needed. They must also decide up front how much time and capital each will contribute, etc.
Types of Partnership
General Partnership (GP)
Partners divide responsibility for management and liability, as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently. All partners are personally liable for business debts. Any partner can be held totally responsible for the business and any partner can make decisions that affect the whole business.
Limited Partnership (LP)
An LP is a form of partnership that has two types of partners, general partners and limited partners. There has to be at least one general partner and at least one limited partner in every LP.
The general partner manages the operation of the LP. In addition the general partners are personally responsibly for the liabilities of the LP. They are entitled to their share of the profits, which is determined and agreed upon in the partnership agreement. Their role is the same as that of general partners in a general partnership.
Limited partners, on the other hand, only contribute to the business with their monetary investment. They are shielded from personal liabilities, but they can loose their financial investment in LP, if the business incurs losses. Limited partners have no voting powers or no control over the operation of the LP. Limited partners receive payments for their financial investment, similar to the dividend paid to the shareholders of a corporation. Limited partners can loose their status and be held responsible for business liabilities, if they are found to be actively involved in the management of the business. Limited partners don't have to pay self employment tax as general partners do. This is because they only receive dividends for their share of investment in the business and are not considered self employed as long as they stay passive in the business operations.
Limited Liability Partnership (LLP)
An LLP is a form of partnership where all the partners enjoy the limited liabilities (to the extent of their investment) as well as limited input regarding the management decision. The procedures of operation and the distribution of the profits can be spelled out in detail in the limited Liability Partnership agreement.
The partners of LLP are not liable for the negligence or malpractice claims made against other partners. Founding partners can manage the control of the business, without having to give too much say to the junior partners.
Joint Venture (JV)
Acts like general partnership, but is clearly for a limited period of time or a single project. If the partners in the joint venture repeat the activity, they will be recognised as an ongoing partnership and will have to file as such, and distribute accumulated partnership assets upon dissolution of the entity.
Advantages of Partnership
Partnerships are relatively easy to establish, time should be invested in developing the partnership agreement.
With more than one owner, the ability to raise funds is increased.
The profits from the business flow directly through to the partners personal tax return.
The business usually will benefit from partners who have complementary skills.
Disadvantages of Partnership
Partners are jointly or individually liable for the actions of the other partners.
Profits must be shared with others.
Since decisions are shared, disagreements can occur.
Unlimited liability in case of general partners.
The partnership may have a limited life, it may end up upon the withdrawal of death of the partner.
Corporations / Companies
A corporation is an entity organised under the law of a particular state. It is considered by the law to be a unique entity, separate and apart from those who own it. A corporation can be taxed, it can be sued, it can enter into contractual agreements into it's own name. the owners of corporation are it's shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of it's own and does not dissolve when ownership changes.
A corporation is a legal entity that is separate from it's owners (the shareholders). No shareholder of a corporation is personally liable for it's debts, obligations or acts of the corporation. Directors, officers and insiders can bear some liability for their involvement with the corporation.
A company needs to be registered under the "Indian Companies Act 1956". Both articles of associations and memorandum of associations governs the working of a company.
A corporation is identified by the terms "limited" or "Ltd". Whatever the term, it must appear with the corporate name on all documents, stationary and so on, as it appears on the incorporation document.
Advantages of Corporations
Shareholders have limited liability for the corporation's debts or judgements against the corporation.
Corporations can raise additional funds through sale of stocks.
A corporation may deduct or increase the cost of benefits it provides to it's officers and employees.
Ownership is transferable.
The corporation has a life of it's own and continue to exist and does not dissolve when ownership changes.
Corporations can hire specialised manpower or management to look after it's operations, without any interference of the shareholders or owners.
Disadvantages of Corporations
The process of incorporation requires more time and money than other forms of organisation.
Corporations are monitored by federal or state agencies, and as a result may have more paperwork to comply with regulations.
Incorporating may result in higher overall taxes. Dividends paid to the shareholders are not deductible from business income, thus income can be taxed twice.
Limited Liability Company (LLC)
LLC is a relatively new type of hybrid business structure. It is designed to provide limited liability feature of the corporations and the tax efficiency and operational flexibility of a partnership.
LLC's can be member owned (which means the owners are passive members and hire separate salaried management) or member managed (which means the members manage the business, as well as own it). It provides all the benefits of a partnership with limited liability, taxation benefits and stock transferability. Nonresident aliens can be shareholders, and members can manage their business without risking their personal liability. But unlike the corporations, LLC shares can not be publicly traded.
A cooperative is an autonomous, association of people united voluntarily to meet their common economic, social and cultural needs and aspirations through a jointly owned and democratically controlled business. It is a firm owned, controlled and operated by a group of people, who make joint use of their available resources to improve their income.
Each member contributes equity / capital, and shares the control of the firm on the basis of one member, one vote principle (and not in the proportion to his / her equity contribution or the number of shares held). It has an open and voluntary membership, members earn interest on their share capital and surpluses are returned to the members according to the amount of patronage.
Advantages of Cooperatives
Can be owned as well as managed by many members.
Is democratically controlled on basis of, one member, one vote
Limited liability, members can be personally held, for the business's debts.
Profit distribution (surplus earnings) passed on to all members in proportion to their contribution to the business.
Disadvantages of Cooperatives
As a cooperative is owned and controlled by a lot of members, who have equal rights and voting power, decision making process becomes longer compared to other business models.
Requires all members to participate for the business to run successfully.
Extensive record keeping required.