Entering business is risky. The reality is that approximately 70 percent of small businesses will fail by the tenth year of business, with 50 percent failing by year five. It’s not enough to dream about success and have a plan, it’s important to be pragmatic from an organizational standpoint. That means choosing the right legal form of ownership for your risk profile.
There are four primary structures for business and many distinctive classes under those four. The business form determines how things like liability, reporting, control, licensing and funding will affect the business. When deciding how to structure the business, it’s important to have an idea of where it’s going in the long haul so your chosen business structure doesn’t impede growth later. Changing structure along the way can be a costly and time-consuming matter.
Some will tell you that choosing the type of business to classify your company as is arguably the most important choice you make. Choose poorly and you can suffer everything from personal liability to losing control of your company. Understanding what each form entails should be considered carefully. Consulting a lawyer who specializes in business matters can go a long way to protecting you in the coming years as your company grows and changes.
Here are some basic considerations of the five primary legal forms of business.
This is when a company is entirely owned by one person. It could be someone doing photography out of their home or a tradesperson painting homes for clients. It’s easier to get up and running as there's little regulation on sole proprietorship other than requiring a business license. Put simply, the sole owner makes all decisions and reaps all the rewards.
But they also absorb all the liability, and all the company’s debts become their debt. The company’s equity is limited to the owner’s personal resources, and there's zero distinction between their personal and business income. This can hinder them when it comes to financing with everything from buying a new car to acquiring new business equipment.
When the owner thinks they’d like to get out of business and wants to sell their sole proprietorship, it can be complicated to complete.
The second simplest form of ownership is a partnership, which can be classified as either a general partnership or a limited one, depending on a few variables. Common between these is that they're similarly flexible and uncomplicated when compared to the sole proprietorship. Their equity tends to be a sharing of their personal resources, which means a bit more capital to work from. But selling the company can be complicated since it requires a new partner.
A general partnership means both partners are on the hook 100 percent for losses and liabilities after they each invest their labor, money, equipment and maybe property too. If one partner invests considerably more, it doesn’t matter – they’re both 100 percent responsible. This is a more informal business form since it can be an implied or verbal agreement between the partners.
On the flipside, a limited partnership is based upon a clearly drawn agreement between the partners. Limiting personal liability is possible in this arrangement, and it requires filing a certificate of partnership through state authorities.
Partnerships can be ended unilaterally but may need some legal oversight during the process.
Known as an LLC, limited liability companies are something of a blend of the flexibility of a partnership with the liability protections of a corporation. One attribute varies depending on which state it’s operating in, and that’s how it's taxed. In general, instead of the double-dipping taxes that can apply to corporations, LLC partners tend to be taxed at a personal level for income earned through the company profits, while the company doesn't get taxed.
If the parties involved act legally, responsibly and ethically, they should be limited as to their liabilities.
Some disadvantages to LLCs can be through limits placed on the ownership agreements pertaining to different states. Setting LLCs up can be costly, as it can necessitate comprehensive, complex agreements to protect all parties and set out terms of the company. Beyond that, getting the LLC going is also pricey due to the various legal and filing fees required.
Incorporating means to create a corporation, which is the act of legally separating a business from yourself. It becomes a stand-alone entity that generates income and pays its shareholders and/or employees. Obviously, companies like Coca-Cola are corporations, but many self-employed people consider incorporating to protect themselves from liability for work that comes with sizeable risks that could be catastrophic as a sole proprietor or a partnership. Think of a software designer who creates systems for businesses and might need to protect himself in case his systems fail and cause extensive losses for the clients.
The upside is that being a legal entity means profits and losses, and some or most liabilities are confined to the corporation. Personal assets are out of bounds if the company folds. If it’s sold, the business is easily transferable.
The downside is that it’s pricey to form a corporation. Plus, running it costs more too, for everything from legal advice to licensing. There’s much paperwork involved. And the least attractive aspect is taxation; the corporation is taxed, plus any income paid out to shareholders is again subject to personal taxes.
Once it’s agreed that a company should be formed as a corporation, the next step is to choose which version. There are a few varieties to choose from in the United States. Talk to a lawyer and tax professional about the repercussions and benefits of each if you’re interested in incorporating your business. Two important types to know about are:
“S” Corporation: When a corporation’s income gets taxed through shareholders rather than the corporation itself. The catch is that corporations are limited in the number of shareholders it can have if it chooses this tax status.
“C” Corporation: These corporations have their income taxes as an entity separate from shareholders. Shareholders will be taxed for personal income paid on their shares. Corporations that don't opt for S-corporation tax status are, by default, a “C” corporation in the Internal Revenue Code.
What makes incorporating such a process is making a good choice to allow the company to insulate itself from risk, plus be a financial success while giving it room to grow in the future. To figure that out, ask questions like where the company is going, what the risks are, what liabilities exist, what should the tax strategy be and is the company expected to have profits or loss early on.
Then, get good advice and start choosing between “S” and “C” corporations, and other varieties, like private, professional, close, cooperative, controlled and so on.