Choosing a Business's Legal Structure

When starting a new venture, one of the first things you'll have to consider is the legal structure of your business. There are many forms of business organization, such as partnerships, corporations, and nonbusiness organizations like charities and clubs. Here, we'll summarize the three you, as an entrepreneur, will most likely want to consider – sole proprietorships, partnerships and corporations. Each has advantages and disadvantages.

1) Sole proprietorship

If one day you get up and start selling hot dogs on a street corner, unless further legal steps are taken, you're operating under a sole proprietorship. It's the most basic form of business structure. The business is owned by one person, the proprietor, and does not legally exist separately from the owner. Since the business is not a separate legal entity, it's said to be “unincorporated”.

Legally, such a business is not separate from your nonbusiness affairs. You can use the business cash to pay your household bills, buy groceries etc. Your creditors can claim against any nonbusiness assets you might have such as cash in your bank account, your car, your house or anything else of value that you own.

Any earnings you make are reported on your personal tax forms and the government taxes you at the rate normally levied to an individual. You can deduct expenses related to your business from from the earnings of your business to reduce your tax burden.

Depending on the laws of your country, you may be required to register your proprietorship with the government depending on the circumstances. 

Advantages:

  • All profits go to you
  • You get to make all of the decisions
  • Minimal startup costs
  • Minimal regulation, bureaucratic procedures and legal planning required

Disadvantages:

  • Your personal liability is unlimited – you're personally responsible for all obligations of the business
  • Obtaining financing is generally difficult

2) Partnership

Partnerships are businesses with two or more owners. If you enter into a partnership it will most likely be either a “general partnership” or a “limited partnership”.

General Partnership

A general partnership is like to a sole proprietorship in terms of owner liability and tax purposes.  

When entering into a partnership, make sure you set in writing things like:

  • The amount and nature of each parters' contribution (cash, property, patents etc.)
  • How profits and losses are to be allocated between partners
  • What happens if a partner retires, withdrawals, becomes disabled or dies
  • Each partner's management responsibilities

Business earnings are distributed according to the partnership agreement and taxes are paid at the personal level. Because each partner is liable, make sure you trust whomever you choose as a partner. Also, try to selecting a partner with complementary skills - this can add a lot of value to the organization.

Limited Partnership

A limited partnership has both limited and general partners. Limited partners contribute capital and have no voice in managing the business. He or she is limited in liability only up to the amount contributed. General partners on the other hand are responsible for managing the business and have unlimited liability.

Advantages:

  • Each partner can provide startup cash
  • Partners may have complementary skills
  • Low startup costs
  • Minimal bureaucratic procedures

Disadvantages:

  • Unlimited liability for general partners
  • Possible partner conflicts
  • Obtaining financing is generally difficult

3) Corporation

If you incorporate your business, it becomes a separate entity in the eyes of the law. It pays taxes and can be sued just like a real person. Owners of the business (shareholders) enjoy limited liability and are therefore sheltered from claims against the business.

This limit on shareholder liability comes at a cost. If owners are paid with dividends out of business income, these dividends are then taxed at the personal level. Since business income is also taxed, owners must take the hit on both taxes. Different countries have different dividend tax policies. In Canada for example, at the time of this writing, tax policy attempts to reduce this tax burden through a “Dividend Tax Credit” for personal income from dividends for Canadian corporations. In Norway, shareholders receiving dividends from Norwegian corporations are eligible for a full dividend tax credit. 

It's worth your while to look into the different corporate forms available in your country. For example, in the United States, there are variations of the above described corporate form – the “S corporation” and the “limited liability company” (LLC). 

In general, an incorporated business provides the following advantages and disadvantages. 

Advantages:

  • Limited shareholder liability
  • Tax advantages for the corporation
  • Easier to obtain financing
  • Ownership can be transferred via share sale

Disadvantages:

  • More expensive to setup and operate
  • Extensive record keeping required
  • Dividends may be taxed twice

Red Tape

Depending on the business structure you choose and your country or region of business, you may have to register a business name and get one more tax numbers. Your business may require a permit to legally operate. For example if you open a bar, most jurisdictions require a liquor license.

Which Should you Choose?

The answer to this question depends on your situation. Do you need external financing? Is limiting your liability crucial? Review the business legal structures in your jurisdiction to come up with what makes sense for you. Keep in mind, you can change your businesses structure as your business evolves. You may want to start off as a sole proprietorship for simplicity's sake, and if you find that things are working well and the business is growing, you may then decide it makes sense to roll it over to a corporation. Many businesses develop in this way.

 
 
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