One of the important elements that an entrepreneur needs to decide on during the business formation stage is the form or structure of the business. Entrepreneurs identify the relevant business organisation structure based on several factors such as ease of commencing operations, compliance requirements and the costs involved, connectivity and accessibility, availability of required skill set, agreement with other members and need to raise funds among others.
Tax implication is one important element that varies with the business structure. The tax rules differ depending on the business form and hence it is important that you evaluate the pros and cons before finalising the business structure.
Before we move further on this subject, it will be ideal if we glimpse through certain basic concepts of income tax for readers, if any, who don’t have sufficient exposure to the basics of the income tax. We will touch upon a few fundamentals like person, residential status, legal entity, heads of income, financial year, assessment year as defined in Income Tax laws.
A legal entity is a concept that is about defining business as an entity different from its owners. For income tax purposes all business entities except proprietorship are considered as separate legal entities.
Some Income Tax basics
The word person in Income Tax has a meaning entirely different from the common parlance and is very wide and broad under Indian Income Tax Act and embraces in itself Individual / HUF, Company and Firm. Though the definition of person also includes Association of Persons or Body of Individuals, Artificial Judicial Person and Local Authority, we will confine our discussion to the common category of individual, company and firm here.
The concept of the residential status of a person is about defining a person as resident or resident not ordinarily resident or non-resident. We will not get into more details of its definitions and how status impacts tax liability in this discussion. We will consider only residents here. A taxpayer would qualify as a resident of India if she/he satisfies one of the following two conditions:
1. Stay in India for a year is 182 days or more or
2. Stay in India for the immediately 4 preceding years is 365 days or more and 60 days or more in the relevant financial year
It is also important to be aware of the various heads of income. There are five main heads of income according to the provisions of the Income Tax in India as follows:
- Income from Salary
- Income from House Property
- Income from Profits and Gains of Business or Profession
- Income from Capital Gains
- Income from Other Sources
Various provisions and tax rates apply depending on the head of income under which a particular income falls along with factors like person, status.
A legal entity is a concept that is about defining business as an entity different from its owners. For income tax purposes all business entities except proprietorship are considered as separate legal entities. What does it mean to a taxpayer is that income tax is charged to the income of legal entities i.e. business except in the case of proprietorship in which case there is no differentiation between the business and its owner for tax.
In all the other cases, the owners of business will be charged tax for the income they have earned in their personal capacity. For example, the amount received from his / her company or any other company as salaries, sitting fees, consulting fees will be charged to tax in their personal capacities. With the scrapping of Dividend Distribution Tax, the dividend has now been made taxable in the hands of the dividend receiver. Needless to say that income from other sources will also be included as income in individual return.
A financial year, also called previous year, is the year in which the income is earned. Assessment year is the year in which Income Tax Return (ITR) is supposed to be filed and assessed. For example, if the income pertains to the year 2020-21, that is the financial year or previous year. The year 2021-22 is the assessment year relevant to the previous year 2020-21.
How Income Tax is charged to business and entrepreneurs?
Let us examine the tax implications of some major business forms and how income tax is charged to entrepreneurs in different situations.
Limited Liability Partnership or Partnership Firm: An LLC or registered partnership firm is taxed as a separate legal entity different from its partners. In computing the taxable income of a firm any salary, bonus, commission or remuneration that is due to or received by a partner is allowed as a deduction subject to certain restrictions. Where a firm pays interest to a partner, the firm can claim deduction of such interest from its total income subject to a maximum interest rate of 12% per annum.
Any of the above payments made to partners and deductible from the income of the firm to compute its taxable income are taxable in the hands of partners in their individual tax return as per the income tax provisions applicable to individuals at the tax slab rates stipulated in the respective Finance Act. However, the share of profit distributed to partners won’t be taxable in their hands as the profit is already taxed in the hands of the firm before sharing with partners.
Income Tax is charged at the rate applicable to firms (including LLP) for the relevant financial year.
Company: A company is a person having a separate legal entity distinct from the members who constitute it. A company is incorporated as per the provisions laid out in the Companies Act 2013.
The applicable taxes are charged to companies, domestic as well as foreign, as per the provisions of Income Tax. Taxable income is calculated taking various provisions related to recognition of revenue and allowability of expenses into consideration. Expenses are allowed to be deducted from gross revenue based on various provisions of Income Tax which has a very basic requirement that expenses that are deducted must have been incurred for generating the revenue being considered.
Any salary, commission, bonus, allowances paid to directors as per the provisions of Companies Act 2013 are taxable in the hands of members or directors in the capacity as individuals. Dividend, after the scrapping of Dividend Distribution Tax by Finance Act 2020, unlike share of profit of partners, is now taxable in the hands of individual investors or dividend receivers.
Income tax is charged at the rate of 25% in the case of domestic companies having Rs. 400 crore or less in turn over and 30% in other cases. However, there are other provisions like 115 BAA with a lower rate of 22% and Minimum Alternate Tax at the rate of 15%. All the above-mentioned tax rates are basic rates and surcharge and cess will apply as applicable.
One Person Company: One Person Company is a relatively new concept that was introduced in the Companies Act, 2013 to help the solo entrepreneur so that he/she can create a formal company structure without needing a director/partner as is the case with a private company/ partnership. Like a Private Limited Company. An OPC is a separate legal entity distinct from the member who constitutes it.
For taxation, an OPC is recognized as a private company under the Income Tax Act and is therefore subject to the same rate of tax as a domestic company. It is important to note that an OPC can only be incorporated by an Indian citizen resident in India.
Sole proprietorship: A sole proprietorship, as the name suggests, is owned by a single individual. It is not legally recognized as a separate legal entity and is, therefore, an informal structure usually adopted by small businesses. Income Tax does not distinguish between the proprietorship business and its owner and tax is charged and assessed accordingly.
A sole proprietorship is taxed according to the relevant income tax slab applicable to the individual taxpayer and therefore is a more suitable structure compared to an OPC.
Individuals: An entrepreneur is an individual as well as owner or partner or member of a business she/he owns. How business is charged to tax is briefly explained above. The entrepreneur will be charged to tax in his individual capacity for the income he/she receives by way of salary, interest, commission, bonus, dividend, consulting fee etc from the company he/she owns and runs or from other sources.
Individuals are taxed at the slab rates as stipulated in the respective Finance Act. Alternate Minimum Tax: Like Minimum Alternate Tax (MAT) is for companies, as per the Alternate Minimum Tax (AMT) provisions, income tax payable by a non-corporate assessee cannot be less than 18.5% (plus surcharge and cess as applicable) of adjusted total income as defined in section 115JC
In a nutshell, an entrepreneur is subjected to tax in two means, one by way of tax to the business and second by way of tax to the individual.
In a nutshell, an entrepreneur is subjected to tax in two means, one by way of tax to the business and second by way of tax to the individual
House Property Income, Capital Gain
The income by way of rent from house property the entrepreneur owns will also be subjected to tax under Income from Property. However, if owning and renting properties is the business of an entrepreneur, such rental income will be considered as Income and Gain from Business or Profession. Likewise, what is to be noted is that share of profit to partners is not taxed again in the hands of partners but the dividend is taxed in the hands of shareholders.
Income Tax Reliefs and Incentives
We will take a look at certain reliefs and incentives allowed by the Government for small businesses and startups.
For early-stage start-ups, it may be very difficult to keep a track of all the Sales, Expenses, Depreciation and also keep invoices and records of all these. Therefore, to simplify the manner of computation of Income, the Govt has also introduced the Presumptive Scheme of Taxation wherein a person can disclose his Income as below:-
- Income = 50% of value of services provided (applicable for Professionals) if annual turn over does not exceed Rs.50 lakhs
- Income = 8% of total value of goods sold (applicable for businesses) if the annual turn over does not exceed Rs. 2 crore, and where the income is credited digitally, the profits will be considered at 6 per cent. It is important to note that if a taxpayer opts for the presumptive taxation scheme, he won’t be allowed to avail of any deduction provided under Section 30 – Section 38.
Conditions you need to meet for opting for a presumptive taxation scheme under Section 44AD.
1. You must file a presumptive scheme for 5 years continuously.
2. In case you wish to file your income as per regular business before the expiry of the said 5 years, you would lose the benefits of the presumptive taxation scheme and will be disallowed this for the subsequent 5 years.
This Scheme of Presumptive Taxation is only applicable to Individual Proprietors, HUF and Partnership Firms but not applicable to Companies and LLPs.
Tax Incentives for Start-ups
The existing provisions of section 80-IAC of the Act, inter alia, provides for a deduction of an amount equal to 100% of the profits and gains derived from an eligible business by an eligible start-up for three consecutive assessment years out of ten years at the option of the assessee. The eligible start-up is required to be incorporated on or after the 1st day of April 2016 but before the 1st day of April 2022 (This was up to the 1st day of April 2021, extended to 2022 by Finance Act 2021). These 3 consecutive years for which 100% tax exemption is allowed can be chosen by the start-up at its discretion from any of the first 10 years. (Amendment introduced vide Finance Act 2020).
This deduction would be available to the eligible start-up if the total turnover of its business does not exceed Rs. 100 Crores in any of the years beginning from the year of its incorporation.
All eligible start-ups who intent to claim the benefits of such tax incentives would be required to:-
1. Maintain Separate Books of Accounts for Eligible Business
2. Get their Accounts audited by a Chartered Accountant
3. Furnish Audit Report in Form 10CCB along with ITR
Meaning of eligible Start-ups
The benefits of 100% Tax Deduction are not allowed to all start-ups but are only allowed to eligible start-ups. Only the start-ups which satisfy all the following mentioned criteria are considered as an eligible start-up.
1. Incorporated as a Company or LLP
2. Incorporated between 1st April 2016 and 1st April 2022 (Increased from 2021 to 2022 in Finance Act 2021)
3. The Total turnover of the business does not exceed Rs. 100 Crores
4. Certified by the Inter-Ministerial Board of Certification in respect of Eligible Business i.e. it is a business that involves innovation, development, deployment or commercialisation of new products, processes or services driven by technology or intellectual property.
5. Should not be formed by splitting up or reconstruction of a business already in existence.
The scope and purpose of this write-up is to give a broad view as to how income tax gets charged to entrepreneurs. We have not discussed various tax rates, the computation methods, filing, assessments and related procedures. Entrepreneurs need to keep updated on the changes and amendments in various tax laws and rules or will end up in unenviable positions by way of penalties, punishments and legal actions. They should also keep ears and eyes open to know about various reliefs, rebates, exemptions given out to businesses particularly startups through Central and State Finance Bills (Budgets), government notifications, amendments etc. so that they won’t miss out on them.