Businesses – The Incorporation Dilemma

Positive India:Prem Bashani J:
The decision whether to incorporate a business or not is an important decision to make for all businesses at some point of time. The lack of awareness among entrepreneurs and/or the obscure knowledge of the pros and cons of incorporation, together with the uncertainties and risks associated with businesses, drive the decisions of start-up businesses whether or not to incorporate. Added to this, the dilemma as to whether it’s prudent to discuss your business idea with others makes the decision even more tricky. Nevertheless, it’s advisable to consult experts before starting a business. Because, very often the bulk of the incentives coming from government policies associated with businesses are given on the basis of the date of commencement, seed capital and the transparency that comes with the project proposals.

In reality, people just start companies either incorporated or not on the basis of their immediate necessities. Therefore, to kickstart the business and to postpone the decision to incorporate, if the start-up idea allows, is often seen as the ideal way to start a business in most jurisdictions worldwide.

To understand and analyse what suits your business depends on what you plan or expect your business to be like. There are certain fundamentals that usually drive an entrepreneur at the time of starting a business: –

1-The promoter wants the authority and control over the business and its capital as his entrepreneurship is driven solely pledging his own resources, his own business idea and on the faith, he has on himself.
2-The promoter, at the time of start-up, gets exposed to the limits, constraints and challenges associated with mobilising resources and capital for kickstarting a start-up business.
3-The promoter is wary of the risks of delay in the commercial operations as it can erode the capital resources by way of interest pay outs and administrative overheads that can significantly defer break-even.
4-The promoter is always averse to stringent compliance regimes as it can be frustrating and exhaust the business resources with unwanted compliance burden and costs.
5-The promoter is concerned about the higher tax incidence associated with registered businesses. They see it diluting the rewards associated with the business success and multiplying the losses associated with failures.

Small businesses are mostly not incorporated. By not incorporating, the entrepreneur/promoter wields a proprietary control over the business. He has complete autonomy over the conduct of the business operations. He is not answerable to anyone but himself. He can follow his gut and also can have a measured approach to the risks associated with running the business. The reward is his own and need not be shared with anyone. The burden of regulatory compliance is less. The profits of the business are taxed only once at the hands of the individual as income from business.

So, ideally all small businesses and low risk businesses would like to start unincorporated unless the proprietary interests of the business idea belong to many. For example, self-employment businesses like a Kirana store or a saloon or an ice cream parlour require a relatively small capital and carry limited risks. And it doesn’t make sense for them to enter into a compliance regime and expend costs. Also, small businesses worldwide are often outside the tax net. And suffer lesser scrutiny, giving them the freedom to focus their energy on business.

On the flipside, unlimited liability comes with the business failure. Individual can be sued for the failure of the business. Therefore, the losses associated with the businesses don’t stop with the company. It extends to his personal assets. And it can eventually push the entrepreneur into insolvency and bankruptcy. Given the high failure rates of business ventures, it is a very risky proposition.

The benefits of incorporating a company are many. Man is a social animal. So, a system of association is natural to evolve around him. In an association, the benefits of synergy will flow. The corporate governance standards and norms regulated by the statutes make incorporated companies more transparent, reliable and trust worthy. That makes it is easier to raise capital, as equities from the public and debts through loans. Once incorporated, the company is seen as a separate juristic person. It is a separate entity distinct from the promoters. It can buy, sell and own property and is capable of suing and be sued in its own name. And the liability is limited to the company. Meaning, the losses associated with the business stop with the company. It protects the assets of the stake holders viz. the promoters, directors or the shareholders from the company debts. That means the promoter can have a reasonable exit option to limit his risks. Nevertheless, personal guarantees and wrong doings are known exceptions that can lift the corporate veil and the liabilities can befall the stakeholders.

Another advantage of incorporation is its perpetuity and free transferability. The company survives the death of the promoters. So, the business doesn’t get disrupted in the event of an unforeseen circumstance. The contracts and leases entered into by the businesses are protected and saved. Succession planning is easier and comes with very little or no cost. And free transferability of shares allows liquidity at the hands of the stake holders. The transparency ensured by the statutory governance standards brings more accountability and therefore commands better respect in the market both for equities/ debts and sale of products/services. Brand promotion can be easier. Finance institutions find it easier to lend incorporated companies. And the access to funds and resources brings efficiency and expertise into the organisation by attracting better talents.

On the operation side, an incorporated company carry more credibility in the domestic and overseas market owing to its transparency in publishing the audited balance sheets with the regulators that is open to the public. The conduct of the businesses by the directors are also a subject of closer scrutiny through transparent and mandatory declarations. And erring managers are personally penalised. Big businesses and foreign companies prefer doing business with incorporated companies. The scrutiny of financial transactions is lesser for incorporated companies under the evolving AMA and antibribery law regimes. Participating government tenders and ICBs becomes easier.

Subsidies and Tax concessions are extended as incentives as a matter of industrial policies by various governments to attract investments and promote employments. Such policy benevolences benefit mostly the incorporated companies. Also, there are income splitting opportunities for promoters by way of distributing dividends on shares held on inert share-holders in the lesser income bracket.

Today, digitalisation has made incorporation easier and affordable. Compliances are comparitively eased out. Provisions to allow amortized deductions of pre-incorporation expenses have brought down the costs of incorporation. The new “One person company” permitted under the new Companies Act, 2013 comes with limited compliance requirements. An OPC gives a balance between the benefits of incorporation and the desire to retain control and authority over the business by the promoter and to minimise the risk and hold the reward for self.

Therefore, small businesses and MSMEs can explore the option to start as a proprietary / partnership business and can be eventually incorporated when the businesses move to the exponential growth phase, unless the incentives and benefits flowing from the industrial policies and operational necessities require an incorporation at the time of start-up. Big investments, including technological companies that is fully dependent on policy incentives in the form of land allotments, capital subsidies, tax holidays and venture gap fundings that often comes with defined eligibility criterion can go for incorporation at the time of starting up. It will be wiser for all businesses to get incorporated beyond a certain mile stone, where transparency, efficiency, expertise and professional accountability can benefit all the stake holders of such businesses.

The author can be connected at https://www.linkedin.com/in/forensicanalyst/

The Author Prem Bashani J is a Consultant in the domains of GST, Customs, SEZ and Foreign Trade Policy. The author is a former Superintendent of Central Excise & Customs, Department of Revenue, Ministry of Finance, Government of India.