The legal or business entity that an organization chooses to use is an important factor in determining its success. The structure of a business determines how it operates, how taxes are paid, what happens in the event of bankruptcy, and how business decisions are made. The business legal entity chosen can also bring certain advantages and disadvantages, protecting certain parties and increasing liabilities for others. It is important to understand the different business structures available, the legal requirements, taxation implications and the advantages and drawbacks of each, in order to choose the right structure for success.
Types of business structures
The primary types of business entities are sole proprietorships, partnerships, corporations and limited liability companies. Each type of entity has its own advantages and disadvantages in terms of taxation, ownership and liability protections.
Sole proprietorships are the most common type of business structure. It is owned and managed by a single individual who is not required to register or file any paperwork with the government to establish it. All profits and losses belong to the proprietor and are reported on the owner’s personal tax return. The proprietor is personally liable for all debts and liabilities of the business.
Partnerships, also referred to as ‘general partnerships’, involve two or more individuals who operate a business jointly and share in all profits, losses, and responsibilities. A partnership needs to be registered at the state and federal level and, depending on the type of partnership, may need to file the different partnership forms. All partners share unlimited personal liability for the debts and obligations of the business.
A corporation is a legal entity separate from its owners and managers, formed by filing the required paperwork with state and federal governments. It can issue stock, has perpetual life and is liable for its own debts and actions. Corporations are subject to double taxation, meaning that the entity is taxed and then all dividends paid to shareholders have to be taxed on their personal returns.
Limited liability companies
Limited liability companies (LLCs) combine features of both corporations and partnerships. LLCs are not subject to double taxation, and members are only liable for their own debts and taxes. LLCs file special paperwork with the state, and the members share in the profits and losses of the business determined by the LLC operating agreement.
Designing an effective business structure
The business structure should be designed to achieve the specific goals and objectives of the business, such as minimizing taxation and liabilities and maximizing asset protection. The business should consider the following factors as part of designing an effective structure :
The business should consider the different legal requirements for each business structure and take into account the level of formalization and paperwork needed for each. For example, a sole proprietorship is the easiest business structure to set up, whereas a corporation requires more paperwork and formalization.
The type of business structure chosen can affect the amount of taxes paid. For example, an LLC is not subject to double taxation, whereas a corporation is. It is important to consider the taxes associated with each type of structure and make sure to take full advantage of any tax benefits.
Protection of assets
The structure chosen should provide owners with protection from creditors and from their own liabilities. For example, a corporation can provide protection from personal liability for the owners, but an LLC cannot. Depending on the situation, different structures may provide more or less protection for owners’ assets.
Size of business and number of owners
The size and number of owners of an entity can affect the type of structure chosen. For example, a sole proprietorship may be the best choice for a small business with one owner, but a corporation or LLC may be better for a larger business or a business with multiple owners.
Complexity of business
Businesses with more complex operations, multiple owners, and a large number of stakeholders may need to consider more complex business structures, such as a corporation or LLC, in order to protect their assets and ensure that the business is run properly. It is important to consider the complexities of a business when determining the best structure.
Common challenges in business structures
There can be challenges associated with business structures that need to be considered and addressed. These can include :
Difficulty in separating business and personal expenses
In certain types of business structures, such as a sole proprietorship, it can be difficult to differentiate between business and personal expenses. This can lead to tax problems if there is not proper record-keeping of expenses and income.
Complexity of transitioning business structures
It can be difficult to transition to a new business structure if the business expands or the goals of the business change. For example, if a sole proprietor wants to transition to a corporation, the process can be complex and involve paperwork and fees.
Challenges in making decisions
The structure of a business can have an effect on the way decisions are made. For example, in a corporation, decisions are usually made by a board of directors, whereas in a partnership, decisions are typically made by consensus. It is important for business to consider the difficulty associated with making decisions when choosing a structure.
Risk of liability protection
Certain structures, such as corporations and LLCs, can provide liability protection. However, there are potential risks associated with this, such as the risk of having all assets subjected to liability in the event of a lawsuit or other legal action. It is important to consider the potential risk of liability protection when choosing a business structure.
Tips for successful business structures
Choosing the right business structure is key to the success of a business. Here are some tips to help ensure the structure is successful :
- Start small – there is no need to choose a business structure that is too complex for the current stage of the business.
- Understand financing needs – it is important to understand the financing needs of a business and choose the structure accordingly, such as a corporation for securities and an LLC for venture capital.
- Keep track of profit and loss statements – it is important to be aware of the company’s financial health in order to determine the best structure.
- Protect owners’ rights – the structure should provide adequate protection and benefits for owners and shareholders.
- Hire professionals when needed – it is often beneficial to hire professionals to set up the structure and make sure all paperwork is done correctly.
By understanding the different business structures, their legal and tax implications, and the benefits and drawbacks of each, businesses can be equipped to choose the right structure for their needs and set themselves up for success.