From the Knowledge Centre
Structuring a Growing Business: Entity Choice, Shareholding and Family Arrangements
Most Indian businesses grow organically. A proprietorship becomes a firm, a company is added for a new line, family members are given shares informally, and property is held by whoever had the funds at the time. Years later, the structure no longer matches how the business is actually run. Restructuring is possible, but it should be planned.
Questions to answer first
- Who should own what in 10 years? Think about succession, siblings' and children's roles, and possible investors.
- Which businesses carry risk? Keep high-risk operations separate from valuable assets such as property and brands.
- Where will profits be reinvested, and where will they be distributed? This affects the entity choice and the tax cost of withdrawals.
- Will outside capital be needed? Investors expect a company with clean shareholding.
Tax provisions that commonly apply
Gifts and transfers within the family. Gifts from "relatives", as defined in the Income-tax Act, are not taxable for the recipient. However, income from gifted assets can be clubbed with the donor's income. This applies to a spouse, a son's wife and minor children, and to certain transfers to an HUF.
Transfers below fair value. When shares or property are transferred for less than their fair market value (stamp duty value for property, Rule 11UA value for shares), the difference can be taxed in the recipient's hands, and the seller's capital gain can be computed on the higher value.
Deemed dividend. Loans or advances from a closely held company to a shareholder holding 10% or more of the voting power, or to a concern in which they are substantially interested, can be taxed as dividend to the extent of the company's accumulated profits.
Tax-neutral restructuring. Mergers and demergers under a scheme approved by the NCLT (or the Regional Director for fast-track mergers of small companies and wholly owned subsidiaries) are tax-neutral if the prescribed conditions are met. Conversions between forms have their own conditions (see our article on entity conversions).
Bringing family members into the business
- As employees or directors – remuneration must be reasonable for the services rendered. Excessive payments to relatives can be disallowed.
- As shareholders – issue shares at fair value, or transfer by gift with proper documentation. Consider a shareholders' agreement covering exit, transfer restrictions and dispute resolution.
- Through an HUF – suitable for holding ancestral and family property. It is not a means to divert an individual's business income.
- Through a private family trust – used for succession and asset protection. Trusts have specific tax rules: income of a discretionary trust is often taxed at the maximum marginal rate, so the design matters.
Founders and early employees
For start-ups and growing companies, a founders' agreement and an ESOP plan set expectations early:
- vesting schedules for founders' shares
- what happens when a founder leaves
- an ESOP pool size and its tax treatment. Perquisite tax arises on exercise, with deferral available for employees of eligible start-ups.
Valuation
Valuations are needed for share issues and transfers, FEMA transactions, mergers and certain tax provisions. Under the Companies Act, valuations for specified purposes must be done by a Registered Valuer. For FEMA and income tax, a Chartered Accountant or merchant banker may value shares as the rules prescribe. Use the right valuer for the right purpose.
A well-designed structure reduces tax leakage, avoids family disputes and makes the business easier to fund. It is best done before a liquidity event or a succession, not after.
The information in this article reflects the law as on the date of publication and is for general guidance only.