Starting A Business: Choosing a Business Structure

There are 3 issues to consider when deciding on the legal form of your business. These are liability, control and taxes. You should consult with a lawyer and tax accountant due to the complex nature and the long-term implications your legal form will have on your legal obligations and financial impact.

The common legal forms of a business are as follow and we will study them in greater detail.

• Sole proprietorship
• Partnership
• Limited partnership
• Corporation
• S corporation
• Limited Liability Company (LLC)

Sole Proprietorship

Sole proprietorship as the name implies, has only one owner to the business. This is the simplest form and easiest to setup. You usually go through very few formalities at the state level, such as business registration. At the federal level, you only need to keep accurate accounting records.

You have no protection against personal liability. You can not limit your liability against debt repayment. However, you can use insurance to guard against liabilities such as claims for defective products, professional malpractice, injuries and others.

From a tax view, it is usually more advantageous to operate under sole proprietor or limited liability company.

Partnership

Partnerships have many of the advantages and disadvantages of sole proprietorship. The major difference being partnership is meant for 2 or more owners (called partners) while sole proprietorship is meant for 1 owner.

Partners will come together to agree on a Partner Agreement. The partner agreement details how the partners share the obligations, profits and losses, how a partner joins or leaves the partnership, rights of interest to purchase by other partners and any other issues of importance.

Partnerships don’t dissolve upon the death of a partner and the successor or beneficiary will continue to share in the partnership’s profits.

Limited Partnership

A limited partnership is a legal setup for “general partners” to seek financing from “limited partners”. The extent of involvement by the limited partners is only financing. The limited partners have no say in how the business is run. In return, the liability of limited partners are limited to the extent of their investment. The general partners run the business and have full exposure to liability.

Corporation

Incorporation is much more expensive than sole proprietorship and partnerships. The fees range from hundreds to thousands and there are on going operational costs to maintaining a corporation.

The main reason for businesses to incorporate is because of the benefits of limited liability. In small, closely held corporations, lenders usually require the shareholders to sign personal guarantees on loans.

Ownership of the corporation is in the form of shares or company stock. The owners own these shares. And these shares come with voting rights. The stock or shares can be traded from one owner to a new owner.

In the event of the death of a shareholder, ownership of the shares will pass on to the heirs designated by the shareholder.

S Corporation

S corporation offers the owners the benefit of limited liability while doing away with paying income taxes at the corporate level. Profits or losses from the S corporation flow directly to the shareholders, thereby avoiding double taxation.

Because of this tax treatment, some people treat S corporation as partnership. The tax laws regarding S corporations are complex and the costs of starting and maintaining the S corporation could offset the tax advantages.

Limited Liability Company (LLC)

A limited liability company (LLC) has two major advantages over the other legal forms of business.

1. All the members (or owners) can enjoy limited personal liability for the debts of the organization.
2. LLC can avoid double taxation by being qualified for flow-through treatment of income.

LLCs aren’t subject to many restrictions imposed on S corporations, such as limits on the number of shareholders.

Summary table of the different legal structures.

Legal Structure	Simplicity	Liability	Federal Tax of profits	Double Taxation
Sole Proprietorship	Simplest an least expensive to establist and maintain.	Owner has unlimited personal liability.	Owner taxed at individual rate.	No
Partnership	Relatively simple to establist and maintain. Partnership Agreement should be drawn up.	Each partner has unlimited personal liability.	Each partner is taxed at individual rates.	No
Limited Partnership	More complex than simple partnership. Needs formal written agreement.	General partners have unlimited personal liability, while Limited partners are financially liable up to the extent of their investment.	Partners are taxed at individual rates.	No
Corporation	Requires the most formality in establishing and maintaining.	Stockholders not generally liable. Owners usually required to personally guarantee loans.	Taxed to corporation at corporate rates.	Yes
S Corporation	Same as corporation.	Same as corporation.	Shareholders taxed at individual rates.	No
Limited Liability Corporation (LLC)	Hybrid of partnership and corporation. Files articles of organization.	Same as corporation.	Members taxed at individual rates	No

Summary

There is no one single business structure that is suitable for every businesses. Which business structure to choose is a matter of choice. It is dependent on the size of your business and finding a balance among liability, control and taxes.

Previous: Creating a Business Plan.

Next: Deciding whether and how to use an Advisor.