Sole Proprietorship vs One Person Company
For anyone wishing to start a business of their own the primary issue of the greatest importance is the legal skeleton they wish to chose upon which they wish to prop up their business. Broadly speaking there are 4 types of legal structures that can be chosen when one wishes to start their business: Self proprietorship, partnership, LLP or a company.
Each of these structures have many variations which come with their own benefits and drawbacks. Which form is chosen by an individual business ultimately depends on the characteristics and needs of the business. In this piece the author talks about what a sole proprietorship business is and examines its advantages and drawbacks. The necessities needing to be fulfilled as per law (tax & shop & establishments registrations) to start a self proprietorship are explained. Towards the end a sole proprietorship is compared with a One Person Company with similarities and differences elucidated upon.
What is a sole proprietorship?
‘Sole’ means single whilst ‘proprietorship’ means ownership. Sole Proprietorship is a business enterprise that is owned and controlled by one person who possesses the entire authority & responsibility with respect to the business. The practical implication of such an arrangement is that an owner alone gets the entire profit but he is also personally liable. This is so as a proprietorship is not a distinct entity unto itself, rather the business and its owner are identical. This form of business is ideally suited to businesses where the nature of the business is simple and the product’s market is small. Business with small capital requirements and low levels of risk are apt for being run as sole proprietorships.
The advantages of sole proprietorship
A defining feature of sole proprietorships is the ease and informality with which it can be created and dissolved. Since no formal registration is needed there is no cost at all in setting up a self proprietorship (except for certain tax related and business specific registrations). Since one person owns the business and has absolute control he can always make quick decisions and be flexible as well (since even fundamental changes to the business are subject only to his will). Retention of complete control over the finances of the business all of whose profits flow to the owner means that this form of business organization gives a very strong incentive for work to the business owner. Often the sole proprietorship business model is found in lines of work where close personal relations are maintained since the sole proprietor is capable of ensuring adequate one on one relations with both employees and customers. Ensuring the safety of business secrets is also a much easier task in this form of business organization than any other.
Disadvantages of sole proprietorship
The problems with the sole proprietorship model of business are fourfold. Firstly, it can exist only for as long as the owner exists (an end can be put to the business by the owner’s death or insolvency). Secondly, expansion of the business beyond a certain point becomes very tough as since the proprietor cannot be an expert in every aspect of business management more employees are needed. However, good quality employees (whose long term aim is often sharing the benefits of ownership) are difficult to attract owing to the individual centric model that characterizes sole proprietorship. The third problem relates to difficulties encountered in the raising of capital by a single person. Lack of credibility is something that hinders the flow of capital and thus expansion of the size of the business notwithstanding the extent of the success of the business or its product. Lastly, sole proprietors have unlimited liability. This means that in a situation where a sole proprietor fails to meet his debts or business obligations and a lawsuit is filed by a consumer then the personal properties of the proprietor could also be disposed of to satisfy the debts.
One of the positive features of a sole proprietorship is that there are legal formalities that need to be complied with to start it. While no formal registration is needed to start a sole proprietorship there are other taxation and business related formalities that need to be complied with. To begin with it’s generally a good idea to come up with a trade name for the business and get it trademarked. Following the same a bank should be visited and the form for a proprietorship firm be asked for. The business can be run out of home but if the proprietor wishes to run it out of a commercial place then the provisions of the Shop & Establishments Act need to be complied with, the provisions of the Act themselves vary across states. Generally there are provisions requiring an establishment’s owner to get his establishment registered along with a fee that may be specified (information such as the managers name, the establishment address and name and its category may need to be provided). Opening and closing hours are specified in addition to norms relating to work and other miscellaneous activities.
It is mandatory for the proprietor to possess a PAN card (since all the returns are filed in the proprietor’s name). Businesses with a turnover exceeding Rs 9 lakh need to pay a 10% service tax and hence need to be registered. If the business of the proprietor involves the procurement and sale of taxable goods in the state then registration for VAT (Value Added Tax) is needed. If the buying or sale of taxable goods is across different states then registration for CST (Central Sales Tax) is needed. If the proprietor wishes to engage in international trade he needs to obtain an Importer & Exporter Code from the Director General of Foreign Trade. A Professional Tax is something that has to be paid to the government as well if the proprietor has employees. The levy of this tax varies across states with some not having it and others collecting it annually. The Employee State Insurance Act, 1948 requires registration under it if 10 people are employed in a factory and 20 people in establishments other than a factory.
Difference between sole proprietorship and One Person Company
The concept of a One Person Company which has existed in many nations abroad has recently gained recognition with the Companies Act 2013. A One Person Company creates a separate legal entity as contrasted with a sole proprietorship where the proprietor and the entity are one and the same. An OPC allows for the limitation of liability whereas in a sole proprietorship liability is unrestricted and extends to the individual’s assets. A perceived benefit in starting an OPC is that it can help attract investors who were not keen to invest in a sole proprietorship owing to the risks imposed by unlimited liability. An OPC is also exempt from the need to conduct general meetings and board meeting. That said all resolutions passed have to be entered in the minutes book and provisions relating to financial statements and accounts and audits are still applicable. In a sole proprietorship by contrast audits would need to be carried out only as per the Income Tax Act on the turnover exceeding the threshold. The biggest deterrent to chosing an OPC over a sole proprietorship is that an OPC would be charged at the 30% base tax rate, minimum alternative tax (18.5%) and dividend distribution tax (15%) as well. The process of setting up an OPC requires time and paperwork. Expenses in the form of hiring a lawyer and a company secretary to do the necessary drafting work are another deterrent. Further a reason why many individuals would be interested in starting an OPC is the possibility that it could be converted into a Private Limited Company in the future. This is something that should be technically possible but practically difficult at present due to lack of clarity in rules and regulations.
This publsihed in iPleaders here.