Tax planning for new business with reference to form of business

The choice of the appropriate form of business organisation will have to be thought of and decided by the person who intends to carry on business or profession at the beginning itself, because a change in the form of business organisation after the commencement of the business, may attract liability to tax.

A new business can be organised under any of the following forms:

  1. Sole proprietorship
  2. Hindu undivided family
  3. Association of persons or Body of Individuals
  4. Partnership firm/LLP
  5. Company
  6. Co-operative society

The selection of a particular form of organisation would depend not only on the tax aspect but on other considerations also, e.g., financial requirements and resources, requirement of limited liability and many other practical considerations.

However, depending upon the taxable status and level of tax liability of the owners, a selection can be made from the various forms available for setting up a new unit.

  • Sole Proprietorship: In the case of a sole proprietorship concern, one of the important tax disadvantages would be that no allowance or relief would be available to the tax payer in computing his income from business in respect of even a reasonable amount of remuneration attributable to the services rendered by him for carrying on the business. As a result, the taxable income arrived at would be a larger amount than what it would have been if it had been the case of, say, a private company in which the individual himself is the Managing Director. In the case of a private company, the reasonable amount of remuneration to the Managing Director, is allowable as an item of business expenditure and to the extent of this allowance, the taxable income from business would get reduced and correspondingly the incidence of tax would also be reduced.

Under sole proprietorship, the entire income of a business unit gets assessed in the hands of the same person along with other income, while the entire loss and other allowances shall be available for set off in his hands against other income. This may have some advantage in the initial years, after which the possibility of converting it into company/firm may be considered; on such conversion, the questions of possible capital gains tax, etc., will have to be considered.

  • Hindu Undivided Family: The Hindu undivided family as a unit of taxation continues to exist for the purpose of carrying on business as well and there is a large number of cases where business is carried on by the members of the family on behalf on the family. Since the law does not specifically provide for the disallowance of such expenses, it is advantageous to carry on a business through the HUF wherever possible. The income of the family is computed and first taxed in the hands of the family at the rates applicable to it. The income of the family may, thereafter, be divided among the members of the family and the members, in such cases do not attract any liability to tax in view of the specific exemption granted under section 10(2) of the Income-tax Act, 1961. Thus, if a business is carried on by a Hindu undivided family, the advantages which are available in the case of a company could be fully availed of and in addition, the members of the family would not become liable to tax when they receive any portion of the family‘s income.
  • Partnership Firm/LLP: All firms and LLPs will be taxed at a flat rate of 30%. If the total income exceeds Rs.1 crore, surcharge@12% would be attracted.

Further, education cess@2% and secondary and higher education cess@1% would be applicable. There will be no initial exemption and the entire income will be taxed. In computing the taxable income of a firm, certain prescribed deductions in respect of interest and remuneration have to be allowed. The share income of a firm in the hands of the partners of the firm is fully exempt.

  • Company: For any large venture requiring substantial investment and recourse to borrowed funds from banks and institutions, ordinarily the form of a limited company will have to be adopted. Within the company form of organisation, however, several alternatives exist. On the basis of the ownership and control, a company can either be organised as a widely held company, i.e. a company in which the public are substantially interested within the meaning of section 2(18) of the Income-tax Act, 1961. Alternatively, it can be organised as a closely held company. Depending upon the choice of the form of organisation of the company, the following important tax consequences would have to be considered from the view point of tax planning:

(1) The applicability of provisions of section 2(22)(e) regarding deemed dividend in respect of advances or loans to shareholders would also depend on the fact whether or not it is a company in which the public are substantially interested. The fact that the scope of these provision has been considerably enlarged by the amendments made in section 2(22)(e) from time to time, should also be kept in mind.

(2) The provisions of section 79 regarding restrictions on carry forward of losses in the event of substantial change in the shareholding of the company also become applicable if the company is one in which the public are not substantially interested. This aspect would assume particular significance in the case of closely held companies where losses are made and shareholdings are transferred before such losses are fully absorbed.

(3) It is significant to note that domestic companies have to pay tax@17.304% (15% plus surcharge@12% plus cess@3%) on dividend declared, distributed or paid except dividend under section 2(22)(e).

Thus, it can be seen that the concept of deemed dividend under section 2(22)(e) and the provisions of section 79 do not apply to a widely held company.

Subsidiary vs. Branch: The income-tax rate on foreign corporations is higher at 50% or 40%, as the case may be, (plus surcharge @2% if total income exceeds Rs 1 crore and 5% if the total income exceeds Rs 10 crore) as against 30% (plus surcharge@7%, if total income exceeds Rs 1 crore and @12%, if total income exceeds Rs 10 crore) on domestic companies. This is so because distributions by the former are generally not liable to tax in India. Further, certain tax incentives available to domestic corporations are not available to foreign companies. Some instances are amortisation of preliminary expenses, expenditure on prospecting for minerals, export incentives, incentives in respect of foreign projects profits, earnings in convertible foreign exchange, tax holiday profits of ships, hotels, etc.. It is advantageous, from tax angle, for foreign corporations intending to do business in India to do so through a subsidiary instead of directly through a branch.

  • Co-operatives: The co-operative form of business organisation, i.e., a co-operative society would also be advantageous from the tax angle and, in addition to the general benefits flowing from the co-operative form the society, can claim deduction in respect of the reasonable amount of remuneration payable to the members of the society for their services rendered, including the amount of commission, if any payable to them and the interest on the deposits or loans given by them. The co-operative society is entitled to a further tax benefit arising from section 80P under which the income of a co -operative society is exempted from tax under different circumstances depending upon the nature of the income and/or the amount thereof. In addition to the various tax concessions which are available to all assesses, the co-operative society stands to gain substantially by virtue of the special benefits available to it under section 80P. The profits of the society remaining after payment of tax would be distributed by it amongst its members in the form of dividends subject to the relevant legislation.

However, it may be noted that benefit under section 80P has been withdrawn w.e.f. A.Y.2007-08 in respect of all co-operative banks, other than primary agricultural credit societies (i.e. as defined in Part V of the Banking Regulation Act, 1949) and primary co–operative agricultural and rural development banks (i.e. societies having its area of operation confined to a taluk and the principal object of which is to provide for long-term credit for agricultural and rural development activities). This is for the purpose of treating co-operative banks at par with other commercial banks, which do not enjoy similar tax benefits.

From the above analysis of various forms of the organisation and their treatment for income-tax purposes, it may be appreciated that the provisions of the taxation laws have a considerable influence on the entrepreneurs in their choice of particular form of the organisation that they should establish.

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