This article is written by Adv Madhavraje Patwardhan who is a LLM graduate from University College London.

The article states that Deciding whether to incorporate a company involves weighing the legal and financial implications. Incorporation under the Companies Act grants benefits like limited liability, perpetual succession, and access to capital, making it suitable for businesses with external investors or significant financial capital. However, forming and maintaining a company can be expensive and complex, with high professional fees, rigorous compliance requirements, and lengthy, costly procedures for winding up. For smaller businesses or those with uncertain longevity, non-incorporated entities like sole proprietorships or partnerships may be more cost-effective. The choice ultimately depends on the business’s needs for legal protection, governance structure, and access to funding.

Introduction

A company is one that is registered under the Companies Act. This is a central government legislation.

A ‘co’ generally is used to refer to a trading enterprise, but it is not a company in law.^[1] It is simply the name given to a business and may or may not be registered with the state government.^[2] Some consultants may advise that registration is mandatory and is so for the purpose of labour law but not for income tax and establishment purposes. A ‘co’ can begin functioning the day it is ideated. Legally, it is advisable to be registered to comply with labour law and other state regulations. However, legally, it can begin functioning and earn an income on the day of its ideation. This is because the business is done by the individual with other people. He may choose to name his business or may choose not to identify it separately from himself.

Incorporation is the act of law through which a new legal person is born. Only a ‘body corporate’ can be incorporated.^[3] A trading co can merely be established. Not all body corporate or ‘juristic persons’ are companies, but all companies are necessarily body corporate. Public trusts can be a body corporate, LLPs are body corporate, a government officer can be a body corporate, etc. This implies that the law grants them almost equal status to a human or natural person. They are allowed to hold property, open a bank account and conduct business on their own without affecting the people working for them.

With these basics out of the way, let us address the first question:

Why shouldn’t we form a company?

1. Expensive to Start: Forming a company is costly, not due to high statutory fees but because of the high professional fees required for establishment.
2. Expensive to Maintain: While forming a company offers legal benefits like perpetual succession and legal personality, maintaining it is akin to maintaining another person.  This includes filing income tax returns, GST (if applicable), and necessary filings with the Registrar of Companies. The books of accounts need auditing, necessitating the hiring of an auditor, company secretary, and tax consultant. An auditor and tax consultant are supposed to be different as the auditor is an external person who checks on behalf of the income tax. In contrast, the tax consultant examines a company’s books to tell you the best possible solution to reduce your tax liability.

Drafting company documents requires both a company secretary and a lawyer to ensure their usefulness. All these services require hiring professionals and paying their fees.

• Expensive and Time-Consuming to Close: Consultants often do not disclose that closing a company is very expensive and almost impossible. The process of winding up a company, as laid down in the Companies Act, typically takes between 5 to 20 years to receive a closure certificate. This process costs significantly more than setting up the company. Therefore, for young entrepreneurs uncertain about their business’s longevity, starting a company may not be advisable.
• Penal Provisions for Non-Compliance: Failing to comply with the Companies Act, such as neglecting to hire necessary consultants or file required documents, can result in severe penalties for the directors. Additionally, if records are not filed with the registrar, the registrar has the authority to strike off the company after a certain number of years. While this might be a quicker way to shut down a company, the penal provisions still affect the directors.
• Companies are not efficient tax vehicles: especially if the profits are small or negligible, the higher tax rate in a joint stock company can be a severe burden on a fledgling business.

The counter-narrative

1. Not Expensive to close: Advisors, while promoting companies, often dismiss the claim of expense. They contend that the provisions under the Companies Act enable the winding up within one year if the business doesn’t start. It allows for a strike-off u/s 248 after two years of being inactive. The winding-up process under the IBC provides for winding up in 180 days. While this is true, and the statutory fees are low, the professional fees are much higher than the costs of closing a partnership or proprietorship. The time taken, however, is much longer in practice; the timelines are indicative but not exact.
2. Alternate Dispute Resolution: Whether it’s the use of the NCLT or the use of arbitration by companies instead of courts to solve disputes, the process is much faster. Further the use of Shareholder Agreements makes it easier. However, an arbitration agreement can be executed between partners as well. There is however no equivalent to the NCLT, firms would need to use the civil courts.
3. Corporate veil and anonymity: This is the biggest advantage of a company; it separates the owners from the managers and creates a corporate veil. While this is important, the doctrine of piercing the corporate veil stands in the way of misusing this provision. Further, the concept of shadow directors fixes liability on the people actually running a company. This effectively nullifies the value of the corporate veil.
4. Limited Liability: In a partnership or a proprietorship, the liability of the firm is the liability of the individuals as well. However, in a company, the liability of the company is not that of the directors. While this is true in theory, the directors are made liable by various labour laws and by banks, which insist on the directors’ personal guarantees. This reduces the value of limited liability.

When one should form a company:

1. The owners and the operators are different, i.e. investors are present: A company provides a formal structure for governance, delineating the roles and responsibilities of owners (shareholders) and operators (directors and officers). This helps prevent disputes and ensures that the business is managed in a way that aligns with the owner’s interests.

By forming a company, owners can hire professional managers to run the business. This separation allows owners to benefit from the expertise of experienced operators while focusing on strategic decisions or other ventures. In a company, ownership interests can be transferred relatively easily through the sale of shares without disrupting the business’s operations. This flexibility is beneficial for succession planning and bringing in new investors.

When a brand is built, there is a need for perpetual succession. This implies that if a business is reliant on either a certain intellectual property or financial capital without much human intervention, the business is ready to be converted into a company.

• If vast financial capital is deployed: Forming a company enhances access to capital through various channels, from equity and debt financing to government incentives and strategic partnerships. Shares and bonds cannot be issued by a firm; it necessarily needs a ‘body corporate’. It also reduces the risk to the directors, which is a major reason for forming a company.

This improved access to funding is particularly beneficial for businesses with multiple partners, as it enables them to pursue ambitious growth strategies and sustain long-term success.

Solutions

Don’t form a joint stock company; other entities like sole proprietary firms, partnerships, and trusts are better and more cost-effective vehicles.

The overreliance or dependence on auditors to run a company in India is one of the major hurdles, as it makes it more expensive to do so. Instead, the government, to increase the ease of doing business, should relax the requirement for audit, like under the UK Companies Act u/s 477.^[4] The logic of this section is that not all companies are big enough to warrant an audit. Small companies with small profits should be exempt from the requirement of having a statutory audit.

To ensure proper compliance, the documents filed by the company should be accessible for free via the ROC website, and severe penalties should be imposed for furnishing false information. Auditors will argue that it becomes easier to get finance from a bank or institution when the financial information is audited. However, not all companies require lending. Further, the income tax returns of the business should be sufficient for a lender to make a decision, and in exceptional circumstances, the financial institution could ask the company to furnish an auditor report.

^[1] The term Proprietorship or ‘co’ has not been defined under the income tax act 1961 or the Maharashtra shop and establishments act 2017.

^[2] For example under the Maharashtra shop and establishments act 2017, however, that is only required if even one person is employed.

^[3] Companies Act 2013, s 2 (11).

^[4] Companies Act 2006 (United Kingdom), s 477.

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