Before starting a business, you ought to know the types of business structures so you can adopt the most appropriate one. It may appear like a simple decision today, but its impact extends to your business future.
Remember, changing your business structure in the future may come with challenges. That’s why you need to get your structure right from the start. Below, we’ll help you understand the common structures from which to choose.
How a Business Structure Impacts Your Business Future
A business is a legal structure that’s recognized in a given jurisdiction. The legal organization of your business is vital as it influences how it operates within that jurisdiction.
Choosing the right business structure is not just about fulfilling a legal requirement. The business structure you choose may detail the strategic plan you have for your business.
The type of business structure you choose will affect the following aspects of your business:
The amount of liability you hold
The amount of profit you earn
How much you pay in taxes
Your ability to raise capital
The business registration formalities
Factors to Consider When Choosing a Business Structure
As we have seen, your decision on the business structure may impact its future. But how do you choose the right structure when making such a sensitive decision?
Here are the factors to consider when making this decision:
The liability involved in each business structure
The amount of control each structure offers you
Nature of business – for example, if you are offering accounting services, an LLC would be an ideal choice
Government regulations and control
Tax liability for each business structure
Capital available to you
Your investment needs
Continuity of existence
Your investment needs
Number of business founders
Your level of risk tolerance
Your long-term business goals
Types of Business Structures
To choose the right business structure, you have to first understand the options available to you. In this regard, we will be discussing the following business structures:
1. Sole Proprietorship
The sole proprietorship is the simplest organizational structure available to you as a potential business owner. It is the most common form of business structure among SMEs in the country.
When you establish a sole proprietorship, you are the single owner of that business. There are no complex legal requirements for registering a sole proprietorship with the state. You need to register only so you can access the licenses you need to run your business.
Being a sole proprietor means you can make business decisions without consulting anyone. Similarly, you get to enjoy the business profits alone.
The cons of this business structure are individual; you absorb all the business liabilities like debts and other expenses. In simpler terms, your property can be auctioned because of unpaid debts accrued by the business.
Moreover, the business itself has no tax obligation. That obligation solely falls onto you once the business makes a profit. Note: if you are a sole proprietor, you must report the income or loss through a Schedule C (Form 1040) of your personal tax return.
2. General Partnership
The next less complex form of business structure is a partnership. The general partnership structure is created as an association between two or more partners.
The first decision you have to make when entering into a partnership is the type that meets your needs. The two forms of a general partnership include:
The limited partnership structure has both general and limited partners.
The general partner has unlimited liability. They manage the partnership with equal powers, rights, and share of profits and losses.
However, as reflected in the partnership agreement, the limited partners' liability to the business is limited to their investment levels. The limited partners do not participate in managing the business.
The profits from the business are passed through the partners' personal tax returns, like in the case of a sole proprietorship. In addition, the general partner has to pay self-employment taxes.
Limited Liability Partnerships (LLP)
Unlike limited partnerships, the LLP gives all the partners/ owners limited liability. Therefore, you are legally protected from any liability that may arise from the business.
The LLP structure is a flow-through entity for tax purposes. That means the partners will receive untaxed profits; hence you must pay your taxes while filing your personal tax returns. The LLP protects you from taking liability for your partner's mistakes. Having a limited liability means that each partner bears the burden of their mistakes.
Another thing with LLP is that you can include a clause making annual reporting mandatory in your written partnership agreement. The clause improves the level of accountability in your partnership.
One major advantage of LLPs is that it allows you to pool resources together as partners, lowering your business costs. The partnership agreement is flexible, allowing you to let partners in or out of the partnership.
Like in the case of a sole proprietorship, a partnership is easy to form. However, you may need extra paperwork if your state requires registering a ‘doing business as’ (a DBA) name. That implies filing a certificate of conducting business as partners and creating Articles of Partnership Agreement with the relevant state agency.
However, a major drawback of partnerships is the decision-making process. It may be problematic to make any quick decisions, especially when the partners are not on the same page.
3. Limited Liability Company (LLC)
An LLC is often confused with LLP because of the limited liability part. An LLC is more of a hybrid because it can be formed as a corporation or a partnership.
An LLC is formed by filing articles of organization with the relevant state offices. Moreover, it is recommended that you draft an LLC agreement at the time of formation.
The LLC agreement establishes business ownership rules and plans for how your business will operate. The following is a checklist of clauses you can include in your LLC agreement.
Member voting power
The ownership interest for each member
The rights and responsibilities of each member
The business management structure
Profit and loss allocation
The advantage of an LLC is that you enjoy the limited liability privilege. There is no way you can be called upon to pay for any liabilities owed by the business.
Another reason the LLC business structure is preferred is the tax flexibility. You can agree with the other members whether you want to be taxed as a corporation or considered a flow-through entity for taxation purposes.
The limitation of an LLC is that investors are not particularly thrilled about financing such business structures. It is such a risky investment option for those providing external fund sources.
Moreover, there is a lot of bureaucracy about an LLC conducting business in another state. You must apply for authority to conduct business in every state you choose to expand your business operations.
We are now getting to the more complex forms of organizational structures. A corporation is an independent legal entity that exists separately from its owners (shareholders).
To understand the extent of separation you get from a corporation, think of it as an artificial person. Therefore, a corporation can own its assets, sell them, sue, or be sued. Moreover, a corporation can sell stock to raise the funds it requires.
It is best to consult an attorney to guide you on forming a corporation. The rationale is that the laws of forming a corporation may differ for each state.
The independent nature of a corporation implies that it has to comply with federal and state regulations and tax requirements. The entity must produce financial statements at the end of every financial year.
The financial statements are crucial in establishing the amount of tax it owes to the IRS. In the case of a publicly listed corporation, these financial statements have to be audited by an independent auditor.
While a corporation pays its own taxes, you also pay taxes on dividends you receive from the corporation as a shareholder.
On the bright side, a corporation's business structure protects you from any of the corporation's obligations. You also don't have to be involved in any active management of the corporation. You can simply hire a management team to be in charge of running the company.
5. S Corporation
An s corporation is one of the branches of the corporation. However, the s corporation is a better option for small business owners considering changing their business structure to a corporation.
Remember how we mentioned double taxation in corporations? The corporation pays federal and state states, but you are still taxed for the divided earned as a shareholder.
S corporation protects you from this form of double taxation. Income and losses are passed through to shareholders, hence will be included in your individual tax returns.
S corporations also have an added advantage if your business doesn't have inventory. You can use the cash accounting method, which is easier than the accrual method. S corporation also offers you protection from bearing any business liability. The s corporation is legally an independent entity.
However, the s corporation is limited in raising capital using its stock. It is only allowed to issue common stocks, which can only be held by individuals, estates, and specific types of trusts.
Let us Help You Set Up Your Business
Now, you understand the various business structures available to you as a potential entrepreneur. But our help doesn't end there. We also offerbusiness consultation services, including helping you select the ideal business structure and helping get it off the ground. Get in touch now to discuss the nature of the business you want to start.