If you’re one of the many entrepreneurs thinking about starting a business this summer, you’re probably exploring what business structure may work best for you. Choosing a business structure is one of the first and most important decisions you will make as a business owner. It’s important to know that the choice of your business structure will directly affect many aspects of your business including ownership obligations, financing, liability, taxation, and succession. You may already be familiar with the three common business structure choices:
- Sole Proprietorship
Often a sole proprietorship is the simplest and least complicated form of business organization as little needs to be done and it does not create a separate legal entity or tax payer apart from the business owner. You also do not have to share decision making or management responsibilities with other partners. Trade names may be used for branding purposes, but in this scenario, the owner is the business and remains liable for all debts and obligations. This unlimited personal liability of the owner can be a deterrent to entrepreneurs. Available credit may be limited to your personal situation unless you can obtain another person to guarantee or otherwise secure the debts of your business. Otherwise, the reality is that unfortunately, the business will suffer. In many cases, starting with a sole proprietorship can be desirable to test the market, but to later switch to another form, the business may have to be “sold” to the new structure with possible legal and tax consequences. Starting as a sole proprietor and “incorporating later” may not be desirable where liability is a concern or there are assets, financing, or material contracts involved.
Strength in Numbers: Exploring a Partnership
A partnership is when two or more people combine their resources with the aim of gaining profit. Choosing a partnership has great benefits as partners can improve your access to capital and different partners can bring a range of different experiences and skills. Duties and responsibilities are also more manageable as they are spread out. However, there are also distinct consequences that are oftentimes misunderstood or undesirable when going the partnership route. Where a partnership exists, there is no separate legal person nor tax payer; rather it is the partners “together against the world” with the tax result “flowing through” to the tax return of each owner/partner. A partnership has joint and several liability where each partner is fully liable for the debts of the partnership. When operating a partnership, a partnership agreement should be written, as a means of protection of both parties. The partnership agreement would outline how the partners plan to conduct business activity, take on debt, and also dissolve the business.
To Incorporate or Not to Incorporate…
Simply put, a corporation is a separate legal entity and tax payer. Typically the most important reason for incorporating is limited liability. Other perks of choosing this structure is that you may pay less in taxes (and have more tax planning choices) and can often raise capital more easily. Its debts and obligations are its own and do not flow to the shareholder owners. There are important exceptions where the business owner may become personally liable such as:
- source deductions
- workers compensation premiums
- unpaid wages
Additionally, many lending institutions will require a corporation’s debt to be secured by personal guarantees from its principals. In these circumstances, a separate relationship exists between the lender and the guarantor that will form the basis of liability independent of the corporation. However, most trade contracts and other instruments that are executed in the normal course of daily business activities will not lead to liability of the shareholder owner. For these relationships, if the business fails or is unable to meet its obligations, the existence of the corporation will insulate the assets of the shareholders from creditor remedies.
Raising capital can be a challenge for both a sole proprietor and a partnership. Many of the financial institutions will be reluctant to grant credit where there is an absence of a secure income sources. A corporate entity can raise equity with share issues. These share issues can be customized to reflect the individual preferences of investors and therefore make it easier to raise capital. Although there are numerous restrictions and equity financing is highly regulated, corporate equity can offer more choices to grow your business than other business structures.
Planning Is Essential
The choice of your business structure has many consequences and is best considered early on in the life of your business. You can always make changes; however, this will involve traction costs, taxation, and at times difficulties in dealing with third parties such as lenders, landlords, suppliers, etc. Typically any effort in early planning will greatly benefit you and your business.