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The Things to Consider When Selecting a Legal Structure for your New Business!

Knowledge Base Section Three: How to Choose the Right Business Structure

Introduction To the Types of Business Structure

Choosing the right legal business structure for your venture is one of the most important decisions that you will have to make. The impact of your decision will affect the taxes you pay and it will also determine the type of documentation that you will need to supply to the government and tax office. It also has a bearing on personal liability and the ability to raise funds and investment.

It is possible to re-organise a business structure if you decide to go in a different direction, but it is better to get it right from the beginning to avoid unnecessary headaches.

Let’s take a look at the different types of legal structure for your business:

Types of Business Structure

Sole Proprietorship

This is the basic structure for a business. It is one person owning and running the business. If you prefer to work alone this is a good choice, but it means you are personally liable for the company’s liabilities. This type of model is fine for a small business such as a gardener or arts and crafts, but not suitable for businesses that are more involved.

Advantages and Disadvantages of a Sole Proprietorship

Advantages

Easy to Set Up: It is very quick and simple to start and perfect for a one person, small business.

Low on Paperwork: There is very little paperwork involved because you are the sole owner and member of the business without executives or shareholders.

Low Cost Set Up: It is inexpensive to start this type of business and you only have to pay licenses and taxes.

Tax Benefits: As a small business owner and sole proprietor you may be entitled to tax breaks e.g. health insurance deductions. Also, the tax for a sole proprietor is much simpler to do than a limited company.

Easy to Shutdown: You can dissolve your business at any time and there is no paperwork required.

Disadvantages

Funds: Raising funds can be problematic because banks and other organisations are more cautious about lending to sole proprietors. That means you have to use your own savings or turn to family or use your house as equity.

Status: Some companies won’t work with you as sole proprietor including those involving government contracts who may only work with limited companies.

Unlimited liability: That means if the company goes under, your personal assets could be in danger of being acquired to pay off the debts or you may have a legal claim against you. This is why many startups prefer to open a limited company instead, as then the company and you personally are two separate entities. This protects your personal assets e.g. your house, car etc

2. Partnership

This option is best for a company which will be owned by a number of people. A partnership can be two or more people. The two types of partnerships are: General Partnerships and Limited Partnerships

General Partnership

The company is managed by the partner and they are responsible for all legal and financial responsibilities and the day-to-day running of the business. All profits are shared equally in this form of partnership.

Limited Partnership

With a General Partnership, the owners run and manage the business being responsible for all duties, but a Limited Partnership is when the partners are the only investors. They have no authority over the company and they do not have liability for the company’s debt and legal duties. One partner is in control of the company and the partner (s) puts money into the venture and receives a share of the profits.

Advantages and Disadvantages

Advantages

A General Partnership is a lot easier to set up if there are two or more partners who want to be active running the business.
Setting up a partnership gives you a favourable tax status because a partnership does not pay tax on earnings. Also, losses and gains are absorbed by the individual partners.
Each general partner is authorised to borrow money, formulate decisions and take action on behalf of the company which may affect all partners. The limitations of what a partner can or can’t do are set out in the partnership agreement.
A business loan and the potential for expansion is more possible with more than one partner. This is because banks will possibly give more credit depending on the number of partners. This is especially useful if one of the partners has a poor credit score, so the other partners may take out loans to grow the business.
General partnerships still submit tax returns, but they don’t pay income tax. This is because each partner files their shared losses or gains in their individual income tax returns.
Each partner provides the company with their own specialist experience and knowledge to benefit the business. This means the partnership may have a wealth of knowledge and experience between the partners.

Disadvantages

Because of all the needed paperwork and administrative difficulties, limited partnerships are often not the ideal solution for a new business unless you intend to have a large number of passive investors.
Partnerships are more expensive to set up than sole proprietorships because of the legal and accounting services that are required by law.
General partners, like sole proprietors, have personal liability for any debts and responsibilities.
There is a potential for disagreements if one partner has greater experience and wants a large percentage of the shares. However, if you invest more capital, then this is only fair that you receive more of the profits.

Famous Partnerships

One of the most famous partnerships is that of Google Partners Larry Page and Sergey Brin. They invented their own search engine and it later became a global brand. They both met while at university in Stanford and after working on their Phds they created the beta version of Google. It was not long after that when they managed to attract $1 million in investment. Their networth at 16% amounts to a shared $121 billion between the two.

Other famous partnerships include Microsoft, Warner Brothers, Hewlett Packard, Apple, Ben & Jerry’s and Twitter.

3. Corporation

Forming a corporation means that the company has a separate legal entity to the owners. It also means following corporation laws and tax duties. Therefore, it requires hiring an accountant and possibly a legal advisor at times. There are a number of different types of corporations.

Types of Corporations:

C corporations are owned by shareholders. They are regarded as separate entities for taxation purposes. An example of this type of corporation is Morgan Chase & Co, a multinational investment bank and financial services company. There is no limit on the number of investors, so a lot of large corporations use this model e.g. Amazon, Apple etc, as this tax model suits their purposes.
S corporations are particularly suited to small businesses and they avoid double taxation in a similar way to partnerships or LLCs. Owners have limited liability protection. S Corporations do not have double taxation and net profits go to shareholders who pay their own taxes. Sole proprietors and members of LLC are subject to employment tax on net income, but S Corp shareholders only have to pay employment tax for the compensation of their services. Some expenses for staff and shareholders can be recorded as business expenses.
B corporations, aka ‘Benefit corporations’ are for-profit entities created to have a positive influence on society. A classic example is the Body Shop which is dedicated to environmental and social goals and is active in campaigning for animal and human rights etc.
Closed corporations are usually managed by a few main shareholders. The shares are traded publicly and have limited liability protection. Also, they have more flexibility than publicly traded companies and are sometimes called ‘privately held companies’.
A Hobby Lobby is a closed corporation which is essentially a privately held, family-owned venture. Stocks go to family members and are not traded in public.
Open corporations trade in the public market; big name examples include Microsoft and Ford. Open corporations have ownership of the company and anyone is able to invest.
Nonprofit corporations are formed to help others in some way and they receive tax exemption. Big name examples include the Red Cross, Age UK, the Salvation Army, Kickstarter, the American Heart Association and Red Cross. The main purpose of a non-profit is not to focus on profits, but instead on helping a particular group or groups of people, wildlife, environment etc.

Advantages

Corporations provide the owner(s) with liability protection as the company is separate from their personal identity and assets. The corporation’s debt is therefore separate from the owner’s debt which effectively means that your house, car etc are safe from administrators should the venture fail.
Corporations can hold onto some profits and reinvest them into the business which lowers the tax band which they have to pay.
To raise funds a corporation can sell shares to the public. This is something football clubs in the UK practise when they need an injection of money into the club.
Corporations live on after owners and major shareholders die because they are legally separate from their personal identities of the owners and shareholders.
Income and losses from a S corporation are passed through to shareholders and are reported on their individual tax returns. As a result, there's just one level of federal tax to pay.
S corporation owners who do not have inventory can adopt the cash method of accounting, which is less complicated than the accrual approach. Income is taxable when it is received, and expenses are deductible when they are paid, according to this technique.
Limited liability. Stockholders are not personally liable for claims against your corporation; they are only liable for their personal investments.
Investment: S Corporations can have up to 100 stockholders in a S corporation which means that they can have more investors and gain more injection of cash.
Continuity: Corporations are not affected by death or the transferring of shares by its owners. Your business continues to operate indefinitely, which is preferred by investors, creditors and consumers.
Capital: It's much easier to raise large amounts of capital from multiple investors when your business is incorporated.

Disadvantages

The set up of a corporation is more expensive and complex to other types of businesses.
Corporations are incorporated according to government or state laws. You can hire a lawyer to advise you but it is important to understand your legal and financial obligations.
Because of the complexity of a corporation, it means far more accounting and tax filing is required.
Corporation profits are taxed for each partner rather than just once.
Corporations have to pay both federal and state corporate income taxes in the USA. In addition, shareholders’ revenue i.e. dividends, will be taxed on their personal tax returns.

Limited Liability Company

An LLC is a hybrid entity that combines the best aspects of both partnerships and corporations. Referred to as ‘Lacs’, they have been around since 1977. They were created to allow owners the same liability protection as corporations but without having to pay double taxation. The owners' profits and losses go to them directly and they then file their own tax returns.

The amount of shareholders is unrestricted for an LLC and any member or owner is allowed full participation in the company's operations. Articles of of incorporation have to be filed and like partnerships, LLCs have a finite duration.

Limited Liability Company

Advantages:

There is Limited Liability as the personal assets of members are not at risk with the company’s debts
Simple Operations: For an LLC, there are not many restrictions on profit sharing and members can allocate profits as they choose. The main thing is that LLC members may give different amounts of capital investment and time to the LLC.

Disadvantages

Limited Lifespan: When a member leaves the LCC, it is then dissolved. The other members can then decide if they want to form a new LLC or end their collaboration.
Agreements: An Operating Agreement drafted by a legal team defines the duties and roles of the members and management.
Self-Employment Tax filing: LLC Members are regarded as considered self-employed and have to pay their own tax contributions. The total net income of the LLC is liable for taxation.

Cooperative

A cooperative or co-op is a business that is owned and run by a group of people and its services benefit the company members. The Co-op members vote on the direction and running of the business and they also take a share of the profits. They have to select a business name which identifies whether the co-op is incorporated or limited.

Advantages:

Lower rate of taxation: Similar to an LLC, a cooperative doesn't have to tax its members for their income.
Increased Funding Opportunities: Cooperatives may be able to apply for government startup grants.
Discounts: Cooperatives can use their size to get discounts on products and services for all of their membership.
Easy To Set Up: all you need is 10 people and the legal regulations are fairly relaxed with simple registration.
Democratic: it is based on democratic management and all members have an equal vote.
Limited Liability: personal assets of members are not affected by the debts of the co-op.
Stability- A co-operative society has a separate legal existence. It is not affected by the insolvency, mental instability, death, or permanent incapacity by any of the membership. It is relatively stable and tends to last for a long time.

Disadvantages:

Choosing a business name to specify if a cooperative is a corporation, such as incorporated (Inc.) or limited, can be problematic because everyone in the co-op needs to agree on the name.
Limited Resources: The financial strength of cooperative societies is because of limited supply of capital due to the low return on capital invested by members.
Incapable Management: too many cooks can spoil the broth and there may be lack of management experience in a co-operative as it tends to attract part-time workers and not experienced managers. Also, the limited ability to reward workers does not appeal to experienced managers.
Motivation: A cooperative society is formed for the mutual benefit of the group and individuals are not rewarded for their individual effort. Therefore, members may be unmotivated to give everything to the cause.
Arguments: Group conflicts can occur among members after the initial novelty of the co-op wears off. Selfish members may dominate and discord ensues.
5. Rigid Regulations: Governments exert rigid regulation and control over co-operatives. Accounts have to be checkd by the Co-operative Audit Department and accounts must be filed to the Registrar. The regulations can negatively affect the efficiency and flexibility of the co-op.
6. Lack of Competition: Co-ops don’t tend to have much competition with guaranteed markets to supply which can lead to a downturn in the efforts of the members.
7. Secrecy: Cooperative business affairs are openly discussed and any member can check the business records, which means it is very hard to maintain secrecy for the business.
8. Corruption: typically co-ops attract corruption within its membership and management.

THINGS TO CONSIDER WHEN CHOOSING YOUR BUSINESS STRUCTURE

Flexibility

Consider your business goals and plan; which structure aligns best with what you want to achieve. Make sure that the legal structure is flexible enough to make changes when you need to.

Simple or Complex?

Sole Proprietorship is the simplest and easiest to set up, but funding can be an issue. A formal legal agreement is required for a partnership.

Taxation

For limited liability companies and corporations there are strict government and statutory requirements to follow in each country, whereas a sole proprietorship is much simpler. Usually an accountant is necessary for limited companies and corporations.
An owner of an LLC pays taxes just as a sole proprietor does: All profit is considered personal income and taxed accordingly annually.
Individuals in a partnership can claim their share of profits as personal income. It is possible to do quarterly or biannual payment to minimise the effects on your tax return.
Corporations file their own tax returns annually and pay tax on profits after costs have been deducted.

Liability

A sole proprietor is responsible for all debts and could lose their personal assets. A corporation has the least personal liability because it is the organisation that can be sued or asset taken if it goes bankrupt without any personal assets being sold.
An LLC is similar to a sole proprietorship for protection and tax benefits. Partnerships share the liabilities between the partners depending on the legal agreement when the company was set up.

Control

If you want sole control of the business, the best options are a sole proprietorship or an LLC.
A board of directors has control over a corporation.

Capital Investment

Corporations can attract funding more easily than sole proprietorships.
Sole proprietors can only get funds via their personal account by taking out loans or credit.
LLC’s owners do not need to use their personal credit or assets.

Licenses, Regulations etc

Investigate what licences, permits and any legal regulations that your specific type of business has to adhere to. Of course, the simplest type of business is a Sole Proprietorship in that regard, but it may not suit the type of contracts you are looking to get i.e. some government funded organisations may only work with companies with limited status.

END OF SECTION TASKS