October 7, 2019 | 13-minute read (2542 words)
Many businesses including Apple started from the garage. Even today, individuals are running small companies from their kitchen table or a side corner in Starbucks, without considering much about liability, taxes, capital and other essential components. And these components play a major role in selecting the right business structure.
However, when it comes to selecting the business structure, it is a personal decision.
What is business structure?
Business structure is a term used to describe an organization's established legal structure in a particular jurisdiction. The ability of an organization to engage in certain activities, such as raising capital and taking on financial obligations for the company; the amount of taxes it must pay to tax administrators are significantly influenced by its business structure.
Business owners should first take into account their demands and goals as well as be familiar with the characteristics of each business structure before deciding on the kind of legal structure. Corporations, partnerships, non-profits, subsidiaries, holding companies and limited liability companies are a few examples of common business structures.
Your business structure may impact a number of things, such as:
- Everyday activities
- Amount of documents needed
- Personal responsibility risk
- The total tax you must pay
- Possibility of raising capital
Importance of business structure
- While lowering tax and business requirements, it offers protection from personal liability.
- The legal structure of the organization makes it simple to include additional shareholders, investors and co-owners.
- Your business structure is adaptable, allowing for easy ownership transfers and company sales.
- The right structure offers protection from personal liability, continuity and stability for the firm, and easier access to financing.
Types of business legal structure
1. Sole proprietorship
One of the simplest business structure types is sole proprietorship, which entails just one person managing the everyday activities of the company. In sole proprietorship, the company is not treated as a distinctive legal entity. The company profit is therefore combined with your personal income and based on that, tax is prepared. In case of taxes, the owner's tax return includes the business' earnings and expenditures.
For minimal-risk, home-based or retail companies, this structure is effective. Before forming a more official firm, a single proprietorship might also enable an owner to try out their business idea.
You must register for self-assessment and submit an annual tax return if you want to operate as a sole proprietor.
Advantages of sole proprietorship
# Since you are the only business owner, you have complete control over all business decisions and are not required to speak with any other partners, directors or shareholders as you would in other arrangements.
# The business's costs and income will be reported on your personal income tax return because it isn't regarded as an independent company.
# The income generated can be offset by company losses, which could result in a larger tax refund. You also have the benefit of the self-employed tax credit.
# There are no paperwork or government costs involved in starting a sole proprietorship company.
A business structure partnership is owned and run by two or more people. The two types of partnerships are:
# General partnership: A general partnership has at least two owners. Co-ownership is permitted in general partnerships. The partners run the company and are in charge of paying off any obligations. Only personal income taxes are applied to the profits of general partnerships.
# Limited partnership: There are general and limited partners involved in this business structure partnership. To form a limited partnership, you at least need one general and one limited partner. Limited partners often have no business decision powers and solely act as investors in the company and the general partners assume responsibility for the partnership's obligations while also owning and running the company.
Advantages of partnership
- Since the company does not directly pay income tax on its revenue, you are not required to file business tax returns.
- There is less paperwork when establishing a partnership and the partners do not have to adhere to the same standards as those for limited liability firms.
- As there is no tax owed at the partnership level, the earnings are dispersed to the partners who then pay personal taxes on them. As a result, the firm pays no taxes.
- Raising cash is generally simpler for partners than it is for a sole proprietor because everyone funds the company.
- A partnership offers the benefit of shared responsibility when there are numerous owners, allowing the work to be divided according to each person's abilities.
An organization can be structured as a corporation, which grants it a distinct legal identity from its owners. It is difficult and expensive to set up, and it enforces additional laws and regulations on the owners in terms of taxes.
The corporation is widely perceived as the strongest legal form for business owners who need personal liability, debt protection and a considerable development trajectory. Although there are numerous state filings and continuing administrative and regulatory procedures that can be demanding and time-consuming, companies are probably best positioned to bring external investors and shareholders.
Corporations can be classified as either C-corps or S-corps. The tax status of the two entities is the primary difference.
A C-corp is considered a distinct tax paying company, so it files its own tax return. Any corporate earnings earned by a C-corporation are taxed at the corporate rate, where the entity pays tax. The business earnings that are allocated to the owners as shareholders are subject to personal income tax. Thus, C-corps have to pay double taxes.
Advantages of C-corp
- Personal assets are protected since owners are not held accountable for a corporation's debts. A company can file and be served with litigation as it is an autonomous body, but you are not held personally accountable for such legal proceedings.
- Companies can raise money by selling their stock and giving shares to its employees as incentives. It fosters the company's growth and provides assistance when necessary.
- Corporations can write off some benefits offered to employees, such as retirement plans, life insurance and other related costs, as owners pay a double tax on corporate earnings.
In order to reduce its federal tax liability, S-corps opt to transfer business profits, losses, deductions and credits to the shareholders. For the purpose of filing taxes, the entity must still disclose income, losses, deductions, credits, etc. Federal income tax is paid at the individual tax rates by S-corp shareholders on their personal tax returns, which also include the corporation's profits and losses. S-Corps evade double taxes.
Advantages of S-corp
- S companies do not subject the shareholders to personal liability for the obligations and liabilities of the company. This enables them to safeguard their own property.
- Since an S company is an independent legal entity, shareholders are at an advantage to sell their shares without incurring any tax obligations.
- Only the company's owners or shareholders are subject to taxes. By choosing to run your business via the IRS an S Corp can avoid paying double taxes.
4. Limited liability company (LLC)
A Limited Liability Company (LLC) is another business structure type, which is seen as a separate legal entity from its owners and is treated as such by the law. It follows that the business's founders can maintain financial and asset separation. A limited firm distributes its revenues to its members after paying the necessary corporate taxes.
Both partnerships and corporations' traits may be found in it. While lowering tax and business requirements, it offers business owners protection from personal liability. The business's gains and losses are distributed to the owners, and each one of them is obligated to report a portion of those gains and losses on their tax returns.
Advantages of limited liability company
- An LLC is a separate legal entity, therefore any debts or legal actions brought against the LLC are not your personal responsibility.
- Even though you can lose the money you put in the firm, your personal assets will be protected if it goes bankrupt.
- There is no limit to having the shareholders in an LLC business structure; each of the shareholders will have an active part in running the business.
- Compared to a corporation, which employs executives to run daily operations and a board of directors to supervise policy, it provides more flexible administration.
Things to consider while choosing the business structure
Determining how much control each person needs to function in a corporate organization is also crucial. For example, a sole proprietorship or limited liability company is the best option if your goal is the primary control. Such control is also possible in the partnership business structure as well.
2. Capital investment
The capital investment is a necessary thing to consider for the efficient operation of the firm. Maintaining all needs in line with the company's capabilities is vital for the company to prosper.
For example, by selling shares or obtaining more capital, corporations can obtain funding from other sources like investors and bank loans. Sole proprietorship businesses borrow money from themselves or hire partners. Although it might be challenging for an LLC to raise money, the owner does not necessarily have to utilize their own resources or credit.
After reviewing your objectives and company strategy, assess how each structure fits into your objectives. Instead of limiting possibilities, the framework should encourage transformation and growth.
Businesses that manage their operations with limited staff must choose a simplified business structure. In order to establish the optimum business structure for your company's activities with the least amount of operational complexity, it is important to understand the objectives and needs of the organization.
For example, a sole proprietorship is considered a simple legal structure. However, in this legal structure, finding outside funding or investors is difficult.
By selecting a model with minimal liabilities, one may take risks without worrying about losing personal assets and doing so will protect the company from any potential losses and debts.
For example, a corporation holds the least level of personal liability, since it is considered to be its own entity by law. While partnerships divide the partners' liabilities in accordance with the terms of their partnership agreement.
Taxation is impacted by a company's organizational design. To find out how the business structure may affect your personal tax status, it is essential to consult with a financial or tax expert.
For example, in sole proprietorship and limited liability companies (LLC), the business owners have to pay personal income taxes.
Based on the requirements presented by the owner, business structures can be selected. Before making a decision, one should weigh the pros and cons of each structure. For more guidance on your business structure selection, consult a CPA or your business attorney.
About Early Growth: Early Growth is the largest national provider of outsourced CFO and accounting services in the venture capital space. For over 10 years, Early Growth has been providing finance and accounting, tax, equity management and fund accounting services to startups at all stages. Early Growth is a strategic partner handling your finances so you can focus on your business, customers and team.
Frequently Asked Questions
What is a sole proprietorship?
A single-owner, unincorporated business is referred to as a sole proprietorship. You become a solitary proprietor as soon as you start a solo side business, freelancing project or new company. Profits from a sole proprietorship are taxed as the owner's personal income and it is possible to recruit staff as long as they obtain an EIN.
What is the easiest business structure to set up?
A sole proprietorship is the easiest business structure to set up and offers you total management over your company. When you form a sole proprietorship, one person is in charge of the revenue and obligations of the business. Since you don't have partners or executive boards, there is relatively less paperwork. State-specific costs vary, but normally the only expenses connected with a proprietorship are license fees and business taxes.
What is the difference between LP and LLP?
In a limited partnership (LP), at least one owner is a “general” partner who makes decisions about the company's operations and is personally liable for those operations. If an LLP exists, all of its owners are protected from unlimited personal liability. Lawyers and accountants are two professions that LLPs work particularly well for.
What is the difference between C-corp and S-corp?
C-corps are distinct taxable entities. They submit a company tax return and make corporation tax payments. If corporate income is transferred to firm owners as dividends, which are regarded as personal taxable income, they may also be subject to double taxation. Whereas S-corps are pass-through taxation entities. They submit a federal informative return, but there is no business income tax payment. Instead profits and losses are “passed-through” to the business and reported on the owners' personal tax returns.
How should I structure my small business?
Your business’s legal structure can establish how much risk your business has in legal proceedings. It can ensure there is no separation between your personal and corporate taxes or it can erect one. It can also affect whether you even require a board of directors and how frequently your board of directors must submit documents. You have a few choices when choosing a business structure type: sole proprietorship, partnership, limited liability company, C-corporation and S-corporation