One of the most important decisions you will need to make when starting a business is deciding on the legal structure of your business. Each type – sole proprietorship, partnership, corporation (general, C and S), and limited liability company – all have their pros and cons. The key is to find the legal structure that will work best for you.
Here are the ten factors you need to consider when choosing the best legal structure for your business:
1. Cost.
The cost of setting up legal structure is an important consideration for startup entrepreneurs. You can form a sole proprietorship quickly and very inexpensively. If you wish to start a corporation or even a limited liability company, it is not uncommon to use a lawyer to help you set up the business or an incorporation service – both of which costs money.
2. Ease of Operation.
How quickly you can set up the business is an important factor to consider when choosing your business structure. For a sole proprietorship, some counties simply require you to apply for business registration, which you can then take to the bank to open a business checking account. Other legal formats such as a corporation or LLC require more documentation and paperwork that can take time to draw up.
3. Tax implications.
The business structure you select has significant tax consequences, so it is important to select the structure that best meets your financial and business needs.
One disadvantage, for example of a C corporation, is that you will be subjected to double taxation. The net business income is subject to corporate income tax, and the monies remaining after the corporate income tax are taxed a second time when they are distributed as dividends to you, which you must then pay personal income tax.
Some business structures such as S corps and LLCs are considered “pass-through” entities for tax purposes; the income of these companies are passed through to their owners and reported on the owners’ personal income tax returns, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation.
The ease of filing your taxes is also an important consideration in choosing your legal structure. As a sole proprietor, you simply file an individual income tax return (IRS Form 1040) including your business losses and profits. Partnerships and some LLCs have to file Form 1065 or Partnership Income Tax Return.
4. Ability to raise capital for the business.
The type of legal structure you choose can impact how your business is viewed by investors, and in the process, your ability to raise capital. Investors prefer a corporation structure, as they often do not want to see a limit in the number of shareholders (e.g. an S corporation can have no more than 75 shareholders) or a pass-through tax setup. You are at a disadvantage if you go with sole proprietorship if your goal is to attract investors to your business.
5. Life of the business.
The life of the business is dictated by the legal structure of the business. Some types of businesses can live forever, while others automatically end upon death, divorce or withdrawal of a partner. When the owner of a sole proprietorship dies, the business entity dies as well.
6. Risk and Personal Liability.
Some business structure exists as a separate legal entity from the owner, while others are not. For some business entities such as sole proprietorship or general partnership, the owner or general partners are personally liable for the debts and obligations of the business. This implies that the personal wealth and assets of the owner can be linked to the business, and thus claims can be made against the owner’s personal assets.
7. Control of the business.
The business structure can also dictate your control of the business. As a sole proprietor, you are the boss and you can make all the decisions. You have total control of the business.
With partnerships and corporations, more people are involved in running and owning the business. Hence, you will need to consult with your partners or shareholders before making any decisions.
8. Public disclosure.
Corporations are mandated to disclose publicly information about the business and finances. Information required include changes relating to the capital structure and managerial control of the corporation, information about borrowing instruments, information about the exercise of shareholding rights, among others.
Sole proprietorships and general partnerships allow you privacy as you will not be required to disclose information to the state.
9. Room for expansion.
The circumstances of your business may change as your business grows. You need a business structure that will allow you to better adapt to your changing environment and face growth opportunities of the business. There may be changes in applicable tax laws, or that you now need to raise additional capital from multiple investors for business expansion. There may also be a shift in your business plan, or increase in risk in your personal liability.
Consider possible growth scenarios that you will be faced and choose the business structure that will cover these possibilities. Otherwise, you may choose to change your business structure to one that better addresses your needs.
10. Terminating the business.
Also consider your exit strategy when choosing the legal structure of the business. You can more easily sell the business as a sole proprietor as you need not get permission from your partners or other shareholders. However, iIf you hoping that the business will grow sufficiently to warrant an initial public offering (IPO), a corporation may be your best bet.
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