Starting a new business means considering a multitude of things and one of them is how you will structure the business legally. It’s a much more important decision than it might sound like – the way you run your business and indeed taxes and liability are often determined by the way the business is structured.
The right choice for your business will depend on both your current resources and the objectives you have for running a business.
The Four Types of Legal Entities for Businesses
There are more than four types of legal entity but only four types of legal entity will be commonly considered for the majority of businesses. These are:
The Sole Proprietorship
The sole proprietorship is a very simple way to go into business. You’re not required to incorporate such a venture – you can start trading today. It’s the most common form of business in North America. However, it’s important to recognize that simplicity has its disadvantages and if you run a sole proprietorship – you are responsible for the company’s debts (as well as making a profit).
Partnerships make a lot of sense in certain fields such as the law or medicine but they’re not the right structure for many other kinds of business. In a partnership a group of people (2 or more) have liability for the company. It is possible to form a limited liability partnership which can reduce the risk of running the business for the partners.
The Limited Liability Company (LLC)
An LLC is designed to allow shareholders to own a company. Shareholders may or may not take part in the day-to-day running of a business. They are, however, responsible for determining who will manage the business and that the business is managed in a legal, ethical and responsible way. As long as they adhere to that responsibility; the LLC shareholder may not be held personally liable for the company’s debts.
There are many different types of corporation and which you choose will require a discussion with a financial advisor; some corporations offer better benefits than others but may have strict criteria for eligibility. However, a corporation is different from the other types of entity because it is considered to be separate from its shareholders. It may sue, it can be sued and it can own property and assets.
What to Weigh Up When Choosing the Best Business Entity for You
It’s possible for a business to feel like a good fit for one or more categories of legal entity. When you’re deciding on which entity is best for your business it’s a good idea to get to grips with the following:
The Effort and Complexity of Start Up
Sole proprietorships are the easiest vehicles to get started and you can report the profits and pay taxes as you would as a private citizen. However, if you intend to seek venture funding or angel investment – you’re going to find that a sole proprietorship is a distinct disadvantage because the investors won’t be able to take a shareholding position in your business. A partnership requires a partnership agreement which stipulates the details between all the people involved in the business as a partner. LLCs and Corporations cost more to start and require additional legal and tax compliance.
The Liability if the Business Fails
A freelancer who intends to incur no debts in the name of the business is probably best off opting for a sole proprietorship; they can use insurance to offset legal liability and if the company carries no debt – they won’t be require to pay it off if things go wrong. However, someone who intends to carry debt with suppliers and run a workforce is probably going to find that an LLC or corporation is better for them because their liability will be strictly limited. Partners will need to determine who is liable for what as part of their agreement or the default position is “jointly and severally” liable – that is if the business gets under – the creditors can take back their money from whoever is most able to pay.
The Taxation Agreements
Corporations and LLCs may be able to reduce, legally, their tax obligations when you compare their obligations to a sole proprietor. Partnerships may have the discretion to pay their income at different points of the year to minimize their overall tax burden. The sole proprietor just pays tax on all profits as personal income.
All of these arrangements can be beneficial and all of the can cause problems for the business owner; it’s always best to discuss with an accountant how you can keep your tax obligations to a minimum without breaking the law.
The Level of Control You Need
A corporation will have a board of directors and control of the company will be shared among those directors. A partnership will share (though not always equally) control of the company between the partners. This can be very useful in terms of steering a business but it can also be very frustrating if you want to be able to dictate every course of action.
If you need total control – you’ll be better off with an LLC or sole proprietorship where you can call all the shots without anyone else’s permission.
The Need for Investment
If you want other people’s money; you need to be able to give them something in return. If you have personal assets you can secure and want to take the risk yourself – you can. But if you want to use the business itself as your asset; you’ll need to choose a structure that investors can invest in – that is an LLC or a corporation.
The Regulatory Environment
Each state has a different set of requirements it places on different types of business. If you want to make sure that you’re only complying with what’s absolutely necessary – the simpler your business structure, in general, the easier it is to be complaint with regulations. It’s a good idea to take advice on this before you decide which business entity to use.