When starting a business, one of the most important decisions owners must make is to choose a legal structure. The structure will affect a number of things about the company, including how it will be run and taxed, and whether it will be recognized as a legal entity separate from its owners. Entrepreneurs must, therefore, strive to select the best structure for their businesses.
Before describing the factors to consider when choosing a legal structure for your company, let’s take a brief look on the most common forms of structures:
When you start a sole proprietorship, you become the only owner of the business. Apart from obtaining the necessary permits and licenses, there is no requirement to register the enterprise with any government authority. You are also fully responsible for the financial obligations of the business.
A partnership is formed when at least two people come together to form a business. In a general partnership, all partners are jointly and equally liable for the financial obligations of the business, while in a limited liability partnership, the liability of some or all of the partners is limited to the amount of capital they pump into the organization.
In the eyes of the law, a corporation is an independent legal entity that pays its own taxes, and can hire employees and face legal action. The owners (shareholders) are completely shielded from liability.
Limited Liability Company(LLC)
Like corporations, LLCs are legal entities, so their owners (members) are not held personally responsible for the company’s losses, debts and other liabilities. But unlike corporations, they are less complex to form and easier to operate.
On to the things to consider:
In business, it’s always advisable to keep personal finances separate from your enterprise. In some situations, however, you may be forced to dig into your pockets and settle a financial obligation for the business. The best way to protect yourself from such unnecessary actions is to choose a legal structure that protects you from financial liability. In this case, you should form a corporation or an LLC. You can also enter into a limited partnership, and ensure the partnership agreement clearly stipulates that you are only liable to the extent of your shareholding, and/or that you are not responsible for the losses and debts incurred by the actions of other partners. Sole proprietorships and general partnerships do not come with any liability protection at all.
2. Startup Costs
Raising sufficient capital to start a business continues to be a challenge facing many entrepreneurs. If you are on a tight start up budget, then you will certainly prefer to set up your company as a sole proprietorship, which is the least expensive structure. The only costs you will incur are for renting a commercial space and getting it ready, purchasing merchandise and securing relevant business licenses and permits.
Partnerships, corporations and LLCs are costly to form, because they must be registered with a competent authority. Owners must pay registration or formation fees, and prepare partnership agreements, articles of incorporation and other documents that cost money to draft. More often than not, you will also need a business lawyer or consultant to help you form an organization with any of these structures.
3. Tax Obligations
It’s a legal requirement to for businesses to pay income taxes. However, different legal structures come with different tax obligations. As a sole proprietor, you are required to report your company or self-employment income in your individual tax returns. Partnerships are also treated similarly, but an informational return indicating the total losses or profits of the business must be filed with the tax authority.
The tax treatment accorded to an LLC depends on whether its membership (number of owners). Owners of single-member LLCs are technically self-employed, so they report business income on their individual tax returns. On the other hand, multi-member LLCs are treated as partnerships, meaning profits and losses are passed through to owners who must then report the income on their personal returns. An information tax return must also be submitted to the taxman.
Since corporations are independent legal entities, they must pay the corporation tax levied on their annual profits. If you choose to start a corporation, you will need to hire a qualified accountant to handle its tax matters.
4. Record Keeping
Keeping proper records is a prudent business practice. But then, it increases operational costs, particularly when you need an extra pair of hands to do the task. If you want an entity that gives you the freedom to organize your records at your own pace, then you need to start a sole proprietorship. There is no regulation that requires sole traders to maintain accurate business records.
Partnerships, LLCs and corporations are legally required to maintain accurate records of financial transactions. In addition to this, corporations must keep a register of shareholders, minutes of annual shareholder meetings and company by laws among other documents.
5. Cost of Running the Entity
When it comes to running a business, a sole proprietorship is the most cost-effective structure. You don’t need to hire an accountant and other skilled professionals to keep it operational. In a partnership or LLC, it all depends on your agreement with other members. If you can agree to share business roles, for instance, the need to hire support staff is eliminated.
Corporations are costly to run. Shareholders must appoint a board of directors, which is responsible for, among other things, hiring senior managers. Other specialized professionals, including accountants and secretaries, must also be brought on board to perform essential day to day tasks. Besides remunerating these professions, corporations must take up workers’ compensation insurance, pay unemployment taxes and purchase expensive business equipment.
6. Profit Sharing
Do you want to have total control over the profits your business generates? If yes, you should either start a single-member LLC, or be a sole trader. Any other structure will see you enter into a profit sharing agreement of some kind. In a general partnership, for instance, profits are shared equally among all the partners by default, whereas profits are shared according to levels of ownership interests in limited partnerships and multi-member LLCS. As for corporations, a portion of annual profits is paid out as dividend per share to all stockholders. The more shares you own, the more money you will earn.
7. Ease of Attracting Capital/Investors
During the course of running a business, it’s often necessary to source for additional capital from lending institutions or external investors. Although banks don’t typically look much into the ownership structure of an organization before lending, investors- especially private equity investors- do. A corporation is by far the best entity to form when you want to attract external investors, because all they need to do is purchase the stock.
LLCs are the least attractive to equity investors as investors don’t want to complicate their personal tax situation by becoming a member in an entity that is taxed as a partnership.
But what if you have set your eyes on securing financing without giving away any equity (like funds from relatives and friends, for example)? The best alternative is to start out as a sole proprietor, and convert into a general or limited partnership as investors come on board. You will, however, need to restructure your partnership agreement to accommodate the demands of new investors.
8. Asset Protection
If you want to run a business without putting your personal assets on the line, avoid starting a sole proprietorship or entering into a general partnership. Without any legal protection from liability, creditors won’t hesitate to come after your property should the business run into debts or file for bankruptcy.
Forming a corporation or an LLC with a partnership agreement that outlines the responsibilities, rights and liabilities of each member in case of a bankruptcy is the most effective way to protect your personal assets.
9. Ease of Closing Down
Entrepreneurs close their companies for various reasons. Perhaps the entity was established to undertake a project within a specified timeframe, the business isn’t turning out any profit or is facing a court order. Maybe even the partners can no longer agree on anything. Whatever the reason, the amount of time, money and level of complexity of closing down largely depends on your business structure.
While sole proprietors can wake up one morning and shut down their businesses without consulting anyone, the situation is a bit complicated for partnerships and even more complicated for LLCs and corporations. In a partnership, the players must revisit the partnership agreement, follow the stipulated dissolution procedure, and then file a statement of dissolution with the competent authority. LLCs and corporations must also file dissolution papers, but after majority of the members or shareholder have agreed to the process and the decision (intention to dissolve) has been published on a public media platform. Where applicable, these entities must also cancel any licenses and permits issued to them, settle outstanding debts and employee wages, and close bank and credit card accounts.
Getting your choice of company structure right is a crucial step to establishing a successful business. With the information fleshed out in this article, you are undoubtedly in a better position to evaluate your options and settle on one that best matches your needs.