What options do you have when you want to start a business with a co-founder or partner, and how can you legally protect yourself? In this blog, we discuss how to structure your business the right way when doing it with a co-founder or partner.
Starting out with a partner, you have three options:
- You could run it as a partnership firm
- You could run it as a Limited Liability Partnership (LLP)
- Or you could run it as a Private Limited Company
Partnership vs LLP vs Private Limited Company
How are all of these different from each other? Here are a few subtle nuances that make all the difference:
- Ease of Starting: It’s really easy to start a partnership firm. You just need to sign a partnership deed to incorporate your partnership. You have to think about things like your profit sharing ratio, how much capital you would contribute, and how much remuneration and interest each partner will get. You also have to have a plan for any unexpected situations. What happens if you later decide to introduce another partner? If one partner passes away, what would happen to his share? Usually, if it’s a two-person partnership and one of them dies, the partnership automatically dissolves. So if you are prepared with a plan for such situations, you can reproduce this on paper and have two witnesses sign it. You could also register your firm at the registrar of firms to incorporate your partnership. You cannot sue anybody if your firm is not registered.
A partnership firm cannot own an asset. So you can’t buy a building in the name of the firm, you will have to buy it in the name of the partners. But the legal structure is different for an LLP, even though it is taxed as a partnership. So if you want to incorporate a limited liability partnership, you have to file an application with MCA, apply for the name, and then it gets incorporated. Likewise, for a private limited company, you have to apply for incorporation with the Ministry of Corporate Affairs, and it’s a separate legal entity with its own name. An LLP and a company can own assets, but a partnership firm can’t.
- Liability: In a partnership firm, all partners are jointly responsible for the liability of any partner they have undertaken. Like suppose you and your friend are partners in a firm, but you aren’t on great terms. If you sign a contract making the firm liable for about 10 crore rupees without the knowledge of your partner, the company you need to pay 10 crores could easily sue you. But if you don’t have any assets, but your rich partner does, the company can go get the money out of them even if they are completely unaware of the agreement that was made or the liabilities that exist. This makes the liability unlimited, and your personal assets could also be attached to the business liability if required. That’s the thing- even if one partner defaults, the personal assets of all the partners are at stake.
This is probably why parents, family members, and advisors detest the idea of a partnership considering how another’s mistake could cost you everything. They realize the liabilities it can put on you, they have probably heard stories of how someone was doing great in their business until their partner went rogue and cheated them. This might just be the biggest loophole in the concept of partnership firms. So to get around this, you might be better off with a limited liability partnership. This isn’t something that was available back then, so parents might not know much about this. An LLP is taxed like a partnership firm, but it comes with the benefit of having a limited liability for every partner. So if you had an LLP and you and your friend both put in 5 lakhs, your liability would only be Rs. 5 lakhs. Then, even if the firm has decided on a 10 crore deal, the creditors cannot come after your assets unless there is an intention of fraud and it’s evident that you have siphoned off the money into your personal accounts. If you can prove that everything is bonafide, your personal assets will be safe.
People go for a Private Limited Company because then that means that nobody can touch your personal assets and you don’t have an unlimited liability towards a third-party. In the earlier days, you only had two options- partnership and Private Limited Company. LLP is a great addition liability-wise.
- Taxation: When it comes to taxation, a partnership and an LLP are not too different. They are both taxed at a rate of 30%, and any profits you draw from the firm are not taxable to you as a partner, but your remuneration has to be computed according to the Income Tax Law. So you get remuneration as per the percentage of profit you are earning. Any profits you make from the firm are tax-free in the hands of partners, and you have to pay tax at a rate of 30% on the income of the partnership firm.
- Compliance: Because a partnership firm is a pass-through entity, if you have not registered it with the registrar, there is no compliance. An LLP mandatorily has to do an annual filing with MCA. Similarly, private limited companies also have to follow a lot of compliances. So while compliances are the highest for such types of companies, One-Person Companies are exempted from a lot of such compliances. For example, they don’t need to have quarterly meetings (as the only person in the company, who are you going to meet, anyway?) In a private limited company, you are supposed to have a board meeting every quarter, and a shareholder’s meeting every year. But if you are a small company, you don’t have to do a lot of compliances. For an LLP, if your turnover crosses 40 lakhs, you need to get an audit done. For a partnership firm, you only have to see the turnover limit and audit limit from an income tax perspective. The income tax limit for a tax audit has now been increased to 5 crore rupees if you are not dealing in cash transactions. So if it’s up to 5 crores, there will be no tax audit for a partnership firm, but there is a mandatory statutory audit for an LLP, and a private company has to get an audit irrespective of the turnover.
- Growth: When a partnership firm begins to grow, it’s very likely that the partners will partake in some kind of a conflict, and then, it becomes essential to protect your assets. So if you are growing, you could incorporate yourself into an LLP. But a private limited company is not bound by how much it can grow. You can grow as much as you want to. Even big names like Amazon and Flipkart are private limited companies despite the massively huge turnover in thousands of crores.
- Succession: For a partnership firm, as long as there are more than 2 partners, if one partner dies, the firm continues with the remaining partners, but you still need to know where the firm stands on the profit-sharing ratios and other important factors. But LLPs and private limited companies can go on for a really long time. Even before starting, there is no limit to how many partners you can take. For a partnership firm, there can only be up to 20 partners at any point of time.
So while it can really be exciting to start your own business or company, it can also get overwhelming to get everything in place. So don’t forget to get a hold of our free checklist that will give you all the steps you need to take when starting out as a small business owner so that you don’t have to face the repercussions of missing any important registrations applicable to you and can avoid any penalties and interest. This is a big decision to make, and we hope you will make it wisely.