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How To Choose The Right Business Structure
There are many different factors one must consider when deciding to start a business. One Factor that could have a major impact on the outcome of the business is the type of business structure you use. There are several different kinds of business structures to choose from. The purpose of this paper is to discuss the different types of business structures available when choosing to start a business or change the business entity. I will contrast the different structures and talk about what would need to be done to set up each structure. I will also talk about personal liability, taxation as well as the advantages and disadvantages of each. I will also explain the types of business structure I would choose if I were to start a business and why.
There are six different types of business structures to choose from Sole proprietorship, LLC, Cooperative, Corporation, Partnership and S Corporations. Each one of these structures will have slightly different characteristics in regards to personal liability, profits, and taxation. The steps needed and costs incurred will also vary depending on the structure you choose. Most business today are either sole proprietorships, Partnerships, Limited liability Companies or LLC’s, or incorporated. I will focus on these entities. “Businesses that operate as sole proprietorships or partnerships don’t legally exist separately from their owners. Businesses that operate as LLCs or corporations are legally distinct from their owners” (Pakroo, P. 2014).
Sole proprietorship is the most basic business structure. “A sole proprietorship is the simplest and most common structure chosen to start a business” (sba.gov). With this structure the business and the owner are basically one and the same. The owner is responsible for all the liabilities of the business. Conversely, the owner also reaps all the benefits of a successful business. To start a sole proprietorship all you have to do is file a few permits and register the business name, if the name of the business is something other than your personal name. Since with this structure you are the business, any profit the business makes is tax at the personal income tax rate. There are many deduction you can use, but taxes are filed using personal income tax forms. Starting a business this way is great if it is a business that will not have a lot of liability. The main disadvantage of this structure is the owner is responsible for the acts of the business. If the business incurs a lot of debt and fails, the owner will still be liable for those debts even when the business no longer exists.
A partnership is formed when two or more people start a business. The partnership does not have to be equal. The partners of a business can divide the responsibilities and profits of the business any way they choose. Although it is best for this agreement to be written, legally, it does not have to be. The intention of a partnership has to be to make a profit. “You must intend to turn a profit” ( Rogers, S. 2012). There are also different types of partnership structures. You can have a general partnership, where each partner shares equally in the running of the business, and the profits are also equally shared. There are limited partnerships. In this structure one or more of the partners will have limited liability from the company and may also have a limited role in the decision making and running of the business. There are also joint ventures. This structure is when there is a partner for a specific period of time, and there for a specific project. Like a sole proprietorship forming a partnership is very simple and inexpensive. Unlike a sole proprietorship, a business formed as a partnership will need to obtain a tax Id number. While all the income and deductions are recorded by the business, the tax itself is paid by the partners of the business. The main disadvantages to forming a partnership is that each partner is not only responsible and liable for their own actions, but also liable for the actions of the business and the other partners. There is also always the potential for disagreements among partners.
Limited liability Company
A limited liability company is like a combination of a partnership and a corporation. An LLC can consist of one or more partners or members. With this structure, the partners are free of personal liability “An LLC takes the advantages of a corporation and combines them with the flexibility and pass through tax treatment of a partnership, has relatively inexpensive startup costs, and is easy to manage. It provides liability protection for both members and managers” (Hopson, J. F., & Hopson, P. D. 2014). There are a few extra steps to forming an LLC. Along with obtaining all the necessary licensing and permits, you will have to file the articles of organization. This is a document that contains basic information about the business. You will also need to file an operating agreement. This is an agreement between the partners outlining the financial structure of the business. Like a partnership and sole proprietorship, the business is not taxed. The taxes of the business are paid by the owner, partners or members of the business. This tax situation is the main disadvantage of an LLC. The business has to operate as if it is incorporated but cannot take advantage of the tax friendly deductions that a corporation has.
“One disadvantage of an LLC is that, if it is not taxed as a corporation, it cannot provide all the tax-deductible fringe benefits of a corporation. Like a corporation, the LLC still needs to thoroughly document meetings on major business decisions by maintaining minutes of the meetings, even if the LLC is a single-member entity” (Hopson, J. F., & Hopson, P. D. 2014).
Corporations are the most complex of all the business structures. The business that is incorporated is its own separate entity, and is entitled to certain rights. To start a corporation you must file the company’s articles of incorporation with the secretary of the state. Some states may require you to also establish directors and issue stock to those initial investors. Corporations file and pay taxes in the business name. Corporations seem to have the best tax situation for owners. The corporation pays taxes on the profit they make but the owners or shareholders of the corporation only pay taxes on the salary received from the company. The tax advantages is one of the main advantages of incorporating. Other advantages include the limited liability as well as the ability to raise capital if needed. The main disadvantages to starting a corporation is the many state and federal regulation you must follow.
If I were to start a business I would start a corporation. My reason for that would be because of all the legal flexibility that an incorporated business has. As the owner I would not have to worry about my personal assets if the company falls on hard times and becomes overwhelmed with debt or any other liability the company may encounter. If the company does well and grows into a very large company, then incorporating becomes an even better advantage as it is easier to raise capital to expand through the selling of stock. Also being incorporated brings a certain about of credibility to the business. When the company name ends with Inc., it gives the perception of a well-established business.
There are several different kinds of business structures one can choose when starting a business. There is no best structure for any particular. People starting the exact same business, may each choose a different business structure. It is probably best to think about the business you are going to start, before choosing a structure. There are many different factors you will have to think about before choosing. Some of these factors are liability, taxation, and exit strategy. Choosing the right structure could be a major reason for the business success or failure
Hopson, J. F., & Hopson, P. D. (2014). Making the Right Choice of Business Entity. CPA Journal, 84(10), 42-47.
Pakroo, P. (2014). CHAPTER 5: Understanding and Choosing a Legal Structure. In , Women's Small Business Start-Up Kit (pp. 147-186). Nolo.
Rogers, S. (2012). Essentials of Business Law. San Diego, CA: Bridgepoint Education, Inc.