Incorporation and Choice of Structure

One of the most critical decisions for a social venture is regarding the choice of the structure. It is important as the right kind of structure would facilitate achieving the objective of the enterprise. And if not chosen correctly, the structure can hinder what the social entrepreneur has set out to achieve. It is also a necessary legal compliance to register ones enterprise appropriately. The first chapter of this handbook lists the various legal structures available to social entrepreneurs and their key features.

1. What is a for-profit entity and what are its characteristics?
2. What is a not-for-profit entity?
3. What are the key features of a “not-for-profit” entity?
4. What are the advantages of incorporating a for-profit and not-for-profit legal entity?
5. What factors should be considered while determining the incorporation of an entity?
6. What are the types of not-for-profit entities in India?
7. What are the types of for-profit entities in India?
8. What are major differences between for-profit and “not for profit” entities?
9. What is procedure for incorporation of for-profit entities?
10. What is the procedure for incorporation of not-for-profit entities?
11. What are the advantages and disadvantages of for profit structures?
12. What is a hybrid structure?

1. What is a for-profit entity and what are its characteristics?

An organization established with the singular objective of maximizing profits and promotion of economic interest is a for profit entity.

Characteristics:

1. These entities operate with the objective to maximize the profits by undertaking commercial ventures;
2. The profits are distributed amongst the members in proportion to their contribution to the capital of the entity;
3. Such entities have easy access to finance; and
4. The donors for donation made to these entities can claim no tax benefits.

2. What is a not-for-profit entity?

An organization that works for promotion of commerce, art, science or is set up for a charitable or religious purpose, without any profit motive, can be termed as not-for-profit entity. Their aim is to provide service to a specific group or the public at large. However, not-for-profit entities are not prohibited from generating profits, if the same is incidental to the activities undertaken by the entity. Such not-for-profit entity is required to channel its profits towards the promotion of the objects of the organisation and not for making payments to its members. Typically the major sources of the income of a not-for-profit entity are donations from their members, grants-in-aid, income from their investments, etc.

3. What are the key features of a not-for-profit entity?

1. The benefits generated by the entities are not limited to the members only and extend to general public or specified sections of the public;
2. The profit is not distributed amongst the members;
3. If registered under the Income Tax Act, 1961 (IT Act), the income of the not-for-profit entities are eligible for tax exemptions; and
4. If the entity is registered under the IT Act, deduction can be claimed by the donor on donations made to such entity, under Section 80G of the IT Act. However, the Finance Bill, 2012, has proposed that any payment exceeding a sum of Rs. 10, 000 shall only be allowed as a deduction if such sum is paid by any mode other than cash.

4. What are the advantages of incorporating a for-profit and not-for-profit legal entity?

The comparative advantages and disadvantages of both, for-profit and not-for-profit legal entity are deliberated later in this Tool Kit based on the parameters given below:

1. Legal, tax and regulatory considerations;
2. Corporate governance and internal management considerations;
3. Limited liability considerations;
4. Source of funding;
5. Type of funding;
6. Scale and sustainability of the business model;
7. Profit sharing and distribution related considerations;
8. Sector specificity of activities; and
9. Transaction costs (i.e. costs of incorporating and administering a legal entity).

The business plan and operational aspects of the entrepreneurial venture dictate these parameters. They need to be analyzed with a qualified business lawyer/ company secretary or a chartered accountant keeping in mind various considerations as given below.

5. What factors should be considered while determining the incorporation of an entity?

If you are looking to register your initiative as a separate legal entity, then do keep the following in mind:

1. First, the investor has to be aware of the different structural options available, which can range from a for-profit entity (such as a company, co-operative society, a partnership firm) to a not-for-profit entity (such as public trust, society). Consideration must be given to the eligibility of the investor in setting up of the selected entity. For instance, a partnership firm can be a member of a Section 25 company, but cannot be a member of other limited liability companies.
2. Secondly, comparative advantages and disadvantages of different structures, based on operational flexibility, regulatory and transaction formalities and costs, taxation, availability of finance, etc, need to be considered. For instance, while a society or trust provides a better option in terms of operational flexibility and taxation advantages, a company may be preferred option for raising capital.

6. What are the types of not-for-profit entities in India?

There are three types of not-for-profit entities in India, namely:

1. Trusts: There are two kinds of trusts that can be formed in India- public and private. A public trust can be formed for cultural, social, public, religious or charitable purpose or both or any other objective of public utility. There is no central legislation in India governing public trusts, although some States (particularly Maharashtra, Rajasthan, and Madhya Pradesh) have enacted legislations governing public trusts. In states where no separate laws for public trusts have been enacted, Section 92 of the Code of Civil Procedure, 1908 is applicable to certain aspects of its governance. The main difference between a private trust and a public trust is that in a private trust the beneficiaries of the trust are specified individuals, whereas in a public trust the beneficiaries are the general public. Private trusts are set up for the benefit of such specified individuals is governed by the Indian Trusts Act, 1882 (Trusts Act). A private trust can be set up for, professional, temporal purposes or as will trusts. The Trusts Act does not apply to religious, charitable or public trusts.
2. Societies: Societies are entities formed for promotion of science, literature, fine arts, knowledge, diffusion of political education and other similar activities. The Societies Registration Act, 1860 (Societies Act) governs such societies. A society registered under Societies Act is not a body corporate. However, under certain State enactments, such as Andhra Pradesh Societies Registration Act, 2001 (AP Societies Act), a society is treated as a body corporate, having perpetual succession, capable of suing and being sued in its own name. In other cases, a society may sue or be sued in the name of the person, determined by the rules and regulations of the society, usually the chairperson, president, etc of the society. Though the society is not a body corporate any judgment/court order will not be enforced against the officer of the society, but will be enforced against the property of the society. Societies are managed by a governing council or a managing committee and are governed by the Societies Act or relevant state legislations, such as AP Societies Act in Andhra Pradesh. The societies registered under the Societies Act differ from co-operative societies, or mutually-aided co-operative societies, since the latter are formed with a profit motive. Societies can be set up for single or multiple purposes. For example the National Health Systems Resource Centre is a registered society set up for the purpose of development of health and family welfare sector. There are also organisations like the Madras Christian Council of Social Service registered under the Societies Act, which are administered by persons of high religious standing, but the primary objective of the society is the promotion of education and community development.
3. Section 25 Companies: A company formed for promoting commerce, art, science, religion, charity or any other useful object,and registered under the Companies Act, 1956 (Companies Act), read with Company Regulations, 1956, is a Section 25 company. A Section 25 company enjoys limited liability like other companies registered under the Companies Act, without the addition of Limited or Private Limited to its name. A Section 25 company can make such an omission to its name only on being granted a license from the Central Government. Such companies are not required to have minimum paid up capital.Further,the members of a Section 25 company are not shareholders of such company and hence no complaint can be made by a member of the section 25 company against it. A Section 25 company is not permitted to distribute profits amongst its members and may use its profits only for the purpose of promoting its objects. Examples of Section 25 companies include Center for Indias Performing Arts, Genome Foundation, Indian Chamber of Commerce and Industry.

7. What are the types of for-profit entities in India?

There are six types of for-profit entities in India, namely:

1. Sole Proprietorship: A sole proprietorship is when one (1) person owns all the assets and liabilities and operates in his or her personal capacity. A sole proprietor is entitled to all the profits and has to bear all the losses of the sole proprietorship concern. Accordingly, any claim against the sole proprietorship concern will also extend to the personal assets of the proprietor. Though no registration of the sole proprietorship is required, the proprietor will have to get other registrations such as registration under the applicable Shops and Establishment Act, etc.
2. Company: A company is a juristic person having a separate legal existence distinct from the members who constitute it and has perpetual succession which means that the company continues to exist despite the death, bankruptcy, insanity, change in membership or an exit from the business of any member, or any transfer of shares, etc, till it is wound up or the name of the company is struck off from the register by the Registrar of Companies, for specific violations under the Companies Act. A Company can be incorporated as:
1. Private Company: A company registered as a private limited company under the Companies Act is a private company. A private company is required to have a minimum of two (2) directors, a minimum of two (2) shareholders and a maximum of only fifty (50) shareholders as per the Companies Act. A private company should have a minimum paid up capital of Rs. 1,00,000 (Rupees One Lakh Only). A private limited company is prohibited from inviting public for subscription of shares or debentures. The articles of association of private companies must restrict the transferability of shares and any invitation or acceptance of deposits except from members, directors or their relatives. In a private company, the liability of each shareholder is limited to the extent of the unpaid amount on the shares held by him/her and is thereby a company limited by shares. A private company can commence business after receipt of certificate of incorporation.
2. Public Company: A public company is a company with a minimum paid up capital of Rs. 5,00,000 (Rupees Five Lakh Only) and is registered accordingly under the Companies Act. A public company is required to have a minimum of three (3) directors and a minimum of seven (7) shareholders. The shares of a public company are freely transferable and there is no limit on the number of members that it may have. Before a company invites investors to raise capital, it is required to publish a prospectus providing information about the company to potential investors. The prospectus has to be filed before the Registrar of Companies (ROC) prior to issuance to investors. If the company decides not to approach the public but obtains capital privately it can file a statement in lieu of prospectus with the ROC. On fulfillment of these requirements, the ROC issues a Certificate of Commencement of business to the public company pursuant to which it can commence its business. A public company also is limited by its shares. A private company, which is a subsidiary of a public company, is also considered to be a public company.
3. Producer Company: The Companies Act provides for Producer Company whereby 10 or more producers of any primary produce may form a producer company. Only producers can be members of such a company. Primary produce as per the Companies Act inter alia, includes produce of farmers arising from agriculture including animal husbandry, horticulture, floriculture, pisciculture, viticulture, forestry, forest products, re-vegetation, bee keeping and farming plantation products: produce of persons engaged in handloom, handicraft and other cottage industries, by-products of such products; and products arising out of ancillary industries. For the purposes of the Companies Act, a Producer Company is like a private company, albeit there is no limit on the number of members it can have. Additionally, a Producer Company cannot become a public company or be deemed to be a public company under the Companies Act.
4. Non-Banking Financial Institution (NBFI): NBFIs are financial institutions, engaged in, inter alia, financing, acquisition of shares/stocks/bonds, insurance business, letting or delivering goods pursuant to hire-purchase agreements. However, a NBFI is not to engage in agricultural business, industrial activity, purchase or sale of goods/immovable property. NBFIs are governed by the Reserve Bank of India Act, 1934 (RBI Act). A non-banking finance company (NBFC) is a non banking institution which is a company and which primarily is engaged in the business of receiving deposits under any scheme or arrangement, or in any other manner, or lending any manner. A company qualifies as a NBFC if its financial assets are more than 50 per cent of its total assets (netted off by intangible assets) and income from financial assets is more than 50 per cent of the gross income. Both these tests are required to be satisfied as the determinant factor for principal business of a company. At present, RBI has classified NBFCs under four categories, viz., asset finance company; loan company; investment company; and infrastructure finance company. Non profit organizations, may convert to a for profit NBFC in the interest of being commercially viable, for example SKS Microfinance converted itself into a for-profit NBFC to accommodate its growth plans.
5. Co-Operative Society: A co-operative society is a body corporate, having perpetual succession, which has, as its main objective, the promotion of economic interests of its members, in accordance with co-operative principles. While Co-operative Societies Act, 1912 (Co-operative Societies Act) is the central legislation, almost all the states have enacted their own state legislations that govern the co-operative societies. The Co-operative Societies Act requires that at least 10 persons, above the age of 18 years, residing in the same town or village need to be members of the entity for it to be registered as a co-operative society. Gujarat Co-operative Milk Marketing Federation is a successful co-operative society which sells AMUL milk products in India, whereby small manufacturers or producers, who are members of the co-operative society, buy the product from individual producers and sell it to a larger market.
6. Limited Liability Partnership (LLP): In India, a LLP is recognized under and is to be registered under the Limited Liability Partnership Act, 2008 (LLP Act). As per the LLP Act, there is a requirement of at least 2 persons to form a LLP, at least 1 of whom should reside in India. There is no prescribed statutory limit on the number of partners a LLP can have. A LLP is a body corporate and has a separate existence from its members. Though it is a partnership, its legal existence is closer to a company. In a LLP, the partners continues to be an agent of the LLP but unlike a partnership each partner does not act on behalf of or as agent of the others partners of the LLP. Like a partnership, a LLP is also governed by a LLP agreement to be signed by all the partners.

8. What are major differences between for-profit and not for profit entities?

Broadly, there are two (2) types of organizations i.e. for-profit and not-for-profit (NPO). Business corporations are usually organized for-profit, while not-for-profit encompasses charities, foundations, trusts, cooperatives and corporations.

9. What is for incorporation of for-profit entities?

The procedure for incorporation for the various for-profit entities is as follows:

1. Sole proprietorship: In India, there is no registration procedure available for a sole proprietorship. The only registration requirements are those required for running the business activity, such as shops and establishment legislation for the establishment, sales tax registration if the business involves transaction in goods, service tax registration, if the activity falls under taxable services.Further, at the time of opening a bank account in the name of a proprietary concern, a proprietary concern needs to provide any two (2) of the following documents, namely, proof of the name, address and activity of the concern. This can be the registration certificate (in the case of a registered concern), or certificate/license issued by the Municipal Authorities under the applicable Shop & Establishment Act, or sales tax returns, or certificate/registration document issued by Sales Tax/Service Tax/Professional Tax authorities, or license issued by the Registering authority like Certificate of Practice issued by Institute of Chartered Accountants of India, Institute of Cost Accountants of India, Institute of Company Secretaries of India, Indian Medical Council, Food and Drug Control Authorities, complete Income Tax return (not just the acknowledgement) in the name of the sole proprietor where the firm’s income is reflected, duly authenticated/ acknowledged by the Income Tax Authorities, utility bills such as electricity, water, and landline telephone bills in the name of the proprietary concern etc.

   Any registration/licensing document issued in the name of the proprietary concern by the Central Government or State Government Authority/Department, as well as the Importer Exporter Code, provided such documents are in the name of the proprietary concern (RPCD.CO.RF.AML.BC. No. 83/07.40.00/ 2009-10 May 12, 2010, as amended by DBOD. AML.BC. No. 38 /14.01.001/2010 11, dated August 31, 2010).

2. Company: Under the Companies Act, read with Companies (Central Governments) General Rules and Forms, 1956 (Companies General Rules), a company can be incorporated by filing specified forms and documents with the Registrar of Companies (RoC), under whose jurisdiction the proposed companys registered office is to be situated.
   • • For incorporation, an application in Form 1A under the Companies General Rules is required to be filed with the RoC, to seek availability of the name.
     • After the selection of the available name, the subscribers to the Memorandum of Association have to apply for incorporation of the company by filing duly stamped Memorandum of Association and Articles of Association; A declaration needs to be signed by a person named in the articles of the proposed company as a Director, Manager, or Secretary of the company stating that all the requirements of the Companies Act and the applicable rules with respect to the registration and other matters have been complied with. Particulars of appointment of Managing Director, directors, manager and secretary or consent of person to act as a Managing Director or director or manager or secretary of the company, has to be submitted to the RoC by filing Form 32. Further, Form 18 has to be filed to indicate the registered office address of the company. All Forms required to be filed with the RoC may be downloaded from the Ministry of Corporate Affairs website at: http://www.mca.gov.in/MCA21/dca/downloadeforms/Download_eForm_choose.html
     • The subscribers also need to pay the fees specified under Schedule X, appended to the Companies Act. For a public limited company, additional formalities include filing of prospectus or a statement in lieu of prospectus is required to be completed to commence the business.
   Upon completion of all the formalities, the company is granted a unique Corporate Identity Number and a Certificate of Incorporation is issued under the signature and seal of the RoC. A public company, which is not converted from a private company, cannot commence business without obtaining a Certificate of Commencement of Business. Any ten (10) or more individuals, or any two (2) or more producer institutions, or a combination of ten (10) or more individuals and producer institutions, each engaged in any activity connected with primary produce can also get a producer company incorporated in the aforesaid manner.
3. Non Banking Financial Companies (NBFC): A NBFC incorporated under the Companies Act, has to obtain a certificate of registration from RBI for undertaking business of NFI, as detailed in para 1.7 (c) above. Any company desirous of undertaking non-banking financial activities, after April 21, 1999, has to have a minimum net owned fund of Rs. 2,00,00,000 (Rupees Two Crores only). However, depending upon the nature of activities, the minimum net-owned fund may vary. For instance, the minimum net-owned fund of an infrastructure finance company is Rs. 300,00,00,000 (Rupees Three Hundred Crores only). Certain entities are exempted from obtaining the certificate of registration, such as a housing finance company, chit company, merchant banking company, insurance company, to name a few. In certain States, such as Maharashtra, there are additional requirements of obtaining licenses under applicable Money Lenders legislations, if the NBFC is involved in money-lending activities.
4. Co-operative Society: The registration procedure of co-operative societies varies from state to state. However, the general procedure involves coming together of at least ten (10) persons and submission of a signed application, along with the prescribed fee, to the Registrar of co-operative societies, along with the copy of the proposed byelaws. The state specific legislations have to be checked for any additional registration requirements. For example, in Andhra Pradesh, a company cannot be a member of any co-operative society.
5. Partnership: A partnership firm can be formed orally or by way of written agreements. However, a written agreement is essential for the purpose of being assessed as a partnership firm under the IT Act, or for the registration under the Partnership Act. The concerned Registrar of Firms issues the certificate of registration. If the agreement is in writing, adequate stamp duty needs to be paid on the instrument as per the applicable rate in the concerned State. Though the registration of partnership firms is optional, it is pertinent to note that an unregistered partnership firm cannot file a suit against third party to enforce its contractual rights. Any change in the constitution of a registered partnership is required to be submitted to and recorded by the Registrar of Firms. Different State Governments have promulgated different rules for the registration of partnership firms in the concerned state.
6. Limited Liability Partnership: All compliances to be completed for incorporation and registration of a LLP is to be done under the Limited Liability Partnership Rules, 2009 (LLP Rules) and the forms prescribed therein. Every LLP shall have atleast 2 partners. Further every LLP is required to have 2 designated partners who are individuals out of which atleast one is a resident in India. The Registrar of Companies (ROC) is the registering authority for LLPs, determined as per the jurisdiction where the registered office of the LLP is situated. For the purpose of incorporation of an LLP an application in Form 1 is required to be filed with the ROC for reserving the name of the LLP. A LLP is required to include the words limited liability partnership in its name.After the reservation of the name, form 2 of the LLP Rules needs to be filled up, along with details on information, such as the proposed business of the LLP, address of the registered office, details of the partners, total monetary value of the contribution. Part B of Form 2 of the LLP Rules requires submission of a declaration from an advocate/company secretary/chartered accountant/cost accountant, certifying compliance with the regulatory provisions and a declaration from a designated partner that all compliance under the LLP Act and the LLP Rules is being met. The registration fees payable by the LLP is to be calculated on the basis of the contribution of the partners. A contribution by a partner to the LLP, may consist of tangible, movable or immovable or intangible property or other benefit to the LLP, including money, promissory notes, other agreements to contribute cash or property, and contracts for services. Details of the LLP agreement, signed by the designated partners are required to be filed in Form 3. Further, Form 4 is required to be filed providing details of the appointment of designated partners. Partners of a LLP are also required to obtain a Designated Partner Identification Number, by filing Form 7. On submission of required documents and applicable forms, the entity would be registered by the ROC as a LLP and a certificate of incorporation will be issued to the LLP. As per the LLP Act, a partnership firm, a private or an unlisted public company can convert into an LLP. However, a listed public company cannot convert itself into an LLP.

10. What is the procedure for incorporation of not-for-profit entities?

The procedure for incorporation for the various not-for-profit entities is as follows:

1. Public Trust: A public charitable trust does not fall within the purview of the Trusts Act. Therefore, there is no specific legislation under which a public trust is registered, except in the States such as Madhya Pradesh, Rajasthan and Maharashtra. A public trust can be created either in writing or orally. The Registration Act, 1908 does not provide for the registration of a trust deed. However, as per the Trusts Act it is compulsory to register a trust in relation to immovable property. If the trust deed is in writing, the applicable stamp duty would have to be paid on it. The procedure for registration of trust differs from state to state. For instance, in Maharashtra, as per the Bombay Public Trust Act, 1950 the trust deed establishing the trust has to be registered by the Charity Commissioner at the registration office set up under the act.
2. Section 25 Company: A Section 25 Company under the Companies Act, was previously granted licenses by the Regional Directors. However, since May 2011, any entity seeking registration as a Section 25 company has to apply to the ROC by filing Form 24 A. Once the license is issued by the ROC, Form 1 (application for incorporation of company), Form 18 (registration office) and Form 32 (particulars of directors, etc.) have to be filed for completion of the incorporation process.
3. Society: Under the Societies Act, any seven (7) or more persons associated for any literary, scientific or charitable purpose, or any other similar purpose under the Societies Act, can form a society. Certain States have enacted specific legislation in this regard and the society is required to be formed in accordance with that state specific legislation, such as AP Societies Act. The procedure of registration varies for each State. However, all the societies must have (a) a memorandum of association, containing the aims and objectives of the society, along with the details of the members of the committee, and (b) bye-laws, containing the rules and regulations. At the time of registration, the applicable registration fees will have to be paid.

11. What are the advantages and disadvantages of for profit structures?

12. What is a hybrid structure?

A hybrid structure is a combination of for-profit and not-for-profit entity, where for-profit and not-for-profit entities jointly function together as a business unit and leverage their respective advantages. The hybrid structure can be of various kinds, such as not-for-profit entity having a for-profit wholly owned subsidiary, or for-profit entity having a not-for-profit arm, or a structure where both the entities operate with each other on an arms length basis.13. Are there any legal hurdles while creating a hybrid structure?The major legal hurdle in relation to hybrid structures is the lack of guidance on efficiently structuring a hybrid entity. Complexities can arise around the governance structure, sharing of intellectual property/brand name of each other, and conflict of interest between the for-profit and not-for profit objectives. The funding of the for-profit and not-for-profit also remains a contentious issue. For instance, a charitable trust is prohibited under IT Act from investing its money in the shares of a private company, unless investment is made:

1. By way of acquiring equity shares of a Depository as defined in clause (e) of sub-section (1) of section 230 of the Depositories Act, 1996 (22 of 1996); ora) By way of acquiring equity shares of a Depository as defined in clause (e) of sub-section (1) of section 230 of the Depositories Act, 1996 (22 of 1996); or
2. By a recognized stock exchange referred to in clause (f) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) (hereafter referred to as investor) in the equity share capital of a company (hereafter referred to as investee)
   1. Which is engaged in dealing with securities or mainly associated with the securities market;
   2. Whose main object is to acquire the membership of another recognized stock exchange for the sole purpose of facilitating the members of the investor to trade on the said stock exchange through the investee in accordance with the directions or guidelines issued under the Securities and Exchange Board of India Act, 1992 (15 of 1992) by the Securities and Exchange Board of India established under section 3 of that Act; and
   3.  In which at least fifty-one per cent of equity shares are held by the investor and the balance equity shares are held by members of such investor;

However, by adopting arms length practices and identifying the objectives and purpose of each entity, along with the common objectives in a well-drafted document, any structural and regulatory hurdle regarding the hybrid structures may be avoided.Top