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Practical differences between Partnerships and Companies

Often, businessmen struggle with the question of whether to structure their business as a Partnership or a Company. We have compiled a short and crisp table to explain the practical differences between the two business vehicles under Indian law.
S. No. Issue Partnership Company
1. Tax liability of the business A partnership firm has to pay taxes only on its profits. Distribution of profits to partners is tax free. A company must pay tax on its profits and a separate tax on dividend distribution, which reduces tax efficiency of the company.
2. Liability of promoters Personal assets of promoters (i.e. the partners) can be attached to pay off the liabilities of the partnership firm. One partner is capable of binding the others through his actions, which increases business risk. Personal assets of promoters are not impacted by the liabilities of the company (unless a promoter provides a personal guarantee for the company’s obligations). A director can at best bind the company, but not other directors, shareholders or investors through his actions, so other parties are relatively safer.
3. Incentive creation mechanisms for employees It is extremely difficult to give equity to employees in a partnership. Sharing profits / losses of the firm makes the employee a partner and capable of binding the firm and other founding partners through his actions, which may not be a desirable outcome for either partners or employees. Therefore, cash-based incentives based on increase in revenue are common in partnership firms. Equity is not shared. Due to the existence of concept of shares, it is easy to give a definite amount of shares to employee without handing over effective control. This incentivizes employees to work hard and benefit subsequently from an increase in the valuation of the company, as they can sell their shares and make a windfall gain. This is especially true of companies in the information technology sector, whose market value has increased hundreds of times in a short span of a few years (e.g. Google, Infosys).
4. Ease of raising capital and foreign investment for expansion Since ownership rights and management rights are not separated, capital-raising from professional investors is not possible as they may not be interested in becoming ‘partners’ of the business.
Foreigners cannot invest in partnership firms in India. This is a huge disadvantage for businesses which want to raise investment and scale up rapidly.
Since ownership rights and management rights are separated, financial investors, venture capitalists and private equity investors are comfortable investing in companies.
Further, majority of the sectors in India are open to foreign investment without regulatory approval. Foreigners can invest in companies as per the Consolidated FDI Policy. Select sectors such as telecom, aviation, banking and insurance require regulatory approval.
5. Foreign loans Foreign loans can be obtained at almost one-fourth the cost of Indian loans – which provides a cheap way to access large amounts of money. However, a business structured as a partnership is not legally entitled to obtain foreign loans. A company is legally entitled to obtain foreign loans in software, hotels and hospitality business and in the manufacturing sector without obtaining regulatory approval.
6. Compliance requirements Compliance requirements for partnerships are minimal and they can carry on business without filing reports. Apart from tax-related filings, they are not required to submit financial statements to regulators. Compliance and filing requirements for companies are quite high. Companies need to file annual report and financial statements, make periodic filings of resolutions in case of certain events and file forms with the Registrar of Companies in case they obtain a secured loan.
7. Related-party transactions Transactions between the partnership firm and the partners individually are not regulated under law. Partners can specify mechanisms to prevent misuse of authority or conflict of interest situations between the firm and the partner. However, the firm needs to be registered if a partner wishes to make a claim of fraud or other wrongdoing against another partner or the firm.  Transactions between directors and the company or between two companies controlled by the same director can be undertaken after observing certain formalities, such as disclosure of the director’s interest or obtaining a board / shareholder resolution, depending on the nature of the transaction.
In short, structuring a business as a partnership is tax efficient and relatively more flexible, but it is a more risky option because of business risks (due to risk of personal liability) and there are several constraints on expansion of the business due to the difficulty of raising capital from large investors and inability to access cheap foreign loans.

However, in case you want to initially start your business as a partnership, you may subsequently convert it into a company to raise investment. Bear in mind that a risk relating back to the time when the business was a partnership can arise even after conversion.

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