There are many steps to consider before beginning your entrepreneurial journey, but deciding on the legal structure of your business ranks at the top of your to-do list!
Before diving any further, let's talk about what we mean by the legal structure of a business.
What Is A Business Structure?
Business structure refers to a company's legal structure; for example, who's the owner? Are they liable for business debts/losses?
It's how a company presents itself in the industry within which it operates and affects day-to-day business operations.
Your business structure determines your tax payable, liabilities, cash flows, and the paperwork you need to have as per tax regulations.
This blog post will focus on three ways to structure your business: Sole Proprietorship, Partnership, and LLC.
There are quite a few types of structures, especially when you enter corporations. Since most people with corporations probably have a legal team behind them, we will focus on the three above as they are the most common ones you will decide on setting up your business with.
Why Is It Important?
Each type of legal structure comes with different laws regarding protecting personal assets and the liability the owners are subjected to. Plus, tax requirements vary for all legal structures.
NOTE: This blog is intended as a starting point. Most of the time, you don't need a lawyer. It just takes time to learn what to do. If you feel overwhelmed, contact a business law lawyer to ensure you pick the correct setup.
So, without further ado, let's get started.
Choosing The Right Structure For Your Small Business
It's time to discuss the main objective of this article, i.e., how to structure your small business. Here are the most common types of business structures:
Sole Proprietorship
A Sole Proprietorship is an attractive option for new entrepreneurs because it's easy to set up, doesn't require countless legal documents to keep track of, and gives you complete control over the business.
To set it up, you start selling and are automatically a Sole Proprietorship in the eyes of the law. It's that easy.
Note: Sole Proprietorship is also known as "sole trading" or "individual entrepreneurship".
Sole proprietors can also get a trade name. Your business will be considered a sole proprietorship by default if you're conducting business activities but have yet to register your startup as any other kind of business.
Legally speaking, you and the business are counted as one entity; your business' assets and liabilities are your assets and liabilities. This means you are liable for everything.
If the business structure is a sole proprietorship, banks, and other creditors can hold the business owner personally liable for the debts, even if you file for bankruptcy.
Businesses that follow this structure often find it challenging to raise money as banks hesitate to lend to sole proprietors since the business owners might need more personal credit. They're worried the loan might not be repaid.
Moreover, sole proprietor businesses can't sell stocks which is a source of capital for some structures, e.g., a corporation.
Overall, it has cons like no protection against liability and difficulty in raising funds. Still, on the brighter side, it's pretty easy to set up, and budding entrepreneurs can test their business model this way before investing more time and cash into forming a more formal business structure.
Partnership
Are you looking to start a business with your friend(s)? This structure may be the right fit for you.
Partnerships involve two or more people as owners of a business. This type of structure is divided into two categories: limited partnerships (LP) and limited liability partnerships (LLP). Let's talk about limited partnerships first. Businesses that follow this have one general partner with unlimited liability while the other partners enjoy limited liability.
Note: Need to familiarize yourself with what liability is? Consider this as what you and your company are responsible for if a customer or employee sues you. Or liability can be anything your company takes responsibility or risk for.
That's not all there's to it, though! The partner with unlimited liability also has more control and ownership over the business than the other partners, as documented in the partnership agreement.
The profits generated by the business pass through personal tax returns, and in addition to that, the general partner pays self-employment taxes.
Moving on to Limited liability partnerships- they differ from limited partnerships in that all partners enjoy limited liability!
Note: Confused about Limited Liability? Just think of the note above and add the word limited. This means your liability becomes limited to what you are responsible for. Debts incurred by the Partnership due to the actions of one partner won't affect your or the other partners' personal assets.
Partnerships are a good business structure to test your business idea with friends. Later, you can switch your structure to a more formal one if needed.
Limited Liability Company (LLC)
A limited liability company or LLC enjoys the best of both worlds, similar to a partnership AND a corporation.
Just like in limited liability partnerships, owners of an LLC are personally protected against the business's liabilities. Simply put, your personal assets remain safe if the business faces jeopardy or lawsuits.
As for the profits, they get passed through to your personal income and save you from paying corporate taxes.
However, you should note something about this structure; members of an LLC business are considered self-employed and are required to pay self-employment taxes.
Another complication that may arise is that if a member leaves the company, some states may ask the business owners to dissolve the current company and form a new one with new membership. This could be a hassle.
Tip: you can avoid this if you already have a legal agreement regarding buying, selling, and transferring ownership.
Which Structure Should You Choose?
Before deciding on which legal structure is most suitable for your business, there are a few things you should take into consideration.
First, what industry type do you plan on operating in? Secondly, how many owners does your business have? Is it just you, or do you have a business partner? And lastly, the size of your business
Deciding on a business structure is a challenging task. If you feel overwhelmed and need clarification, consult legal professionals to guide you in choosing the appropriate structure for your startup.
Final Thoughts
Ultimately, if you are by yourself and just starting a Sole Proprietorship is fine. If you want to mitigate risk to your personal assets, get an LLC. It's easy to get an LLC. You fill out some forms, pay a fee, and are protected.
What we have provided here is a basic understanding of a business structure. We advise you to read more articles and consult a lawyer if needed.