You have many decisions to make when starting a business, and yes, one of the most crucial being the types of business ownership (the legal entity) that you choose.
This subject gives a lot of folk’s sleepless nights, and if you get it wrong, it can cause you financial and emotional pain!
So, Is it confusing? No, honestly, it’s not.
Then why all the sleepless nights? Because people sure like making it so.
Here’s what makes this post different.
I have sat where you are right now, I’ve started and run sole proprietorships, partnerships, and an LLC. And coming from a family of accountants (disclaimer – I am not an accountant I am an SME owner), I’ve spent years on both sides of the fence.
Together we’ll look at the four types of business ownership, what each one means, their pros and cons, and without the often-confusing legal terminology and professional jargon.
But, before we get into the meat and bones we need to talk about business registration, and why it’s important.
Business Registration: A Simple Explanation
To legally trade, you first have to register your business with local, state, or federal authorities so your silent partner (the government) can take its slice of your pie, in the way of taxes.
You have four choices; all very different, and which one you choose depends entirely upon your business circumstances and aspirations.
Your choice will profoundly affect how you operate your business, including the setting up costs, personal liability, and how you file your taxes. But most importantly, for all new business owners, how much the setup and running of the business will cost.
Pretty simple, right!
Good, now we can get started.
If you’re going it alone and willing to take on the legal liabilities (the reward out-weighs the risk), then this is the one for you.
A sole proprietorship is the most popular form of SME (small to medium enterprise) business ownership due to the ease of setting one up. All you need to become legal are the necessary permits and licenses (each state has its requirements), and the funds to begin trading.
Step for forming a sole proprietorship:
- Choose your business name
Register your DBA (doing business as) with local and state authorities
- Register for a business license
- Obtain the required permits and licenses
- Apply for an EIN (Generally only required if hiring employees)
- Get the right insurance
And regarding insurance, the most significant risk of trading as a sole proprietor is litigation; if someone sues you, your assets are at risk.
Consider the following coverage before registering: Property and public liability, auto, health, and disability insurance.
- You’re the boss: Every decision is yours to make
- Easy to set up: No complicated filing forms
- A Simplified taxation process: No double taxation
- Low accountancy costs: A good bookkeeper is more than sufficient
- Low tax rates
- No balance sheet requirements
- Personal liability: As there’s no legal distinction between you and the business if it goes bust so can you!
- Self-employment tax
- Funding: Banks are less likely to lend to individuals
- Public perception: Depending on your business, some clients prefer working with an LLC
- Running a business alone can be a heavyweight to carry
Partnerships also make up a large percentage of the SME world of business. But before you jump into one think of the adage, “there is strength in numbers, but even more so in collective goodwill”.
If you and an acquaintance have a business idea, then a general partnership is your most straightforward option. The initial registration and the ongoing tax liabilities are more complex than a sole proprietorship, but with the reassurance of knowing you’re not in business alone. That’s where “there is strength in numbers” comes into play.
Forming a general partnership:
Partnerships can be formed between two individuals, separate organizations, or both. The responsibilities can be shared evenly, or you can adopt a more flexible approach, for example (one partner’s skill set might suit online sales and advertising while another’s more suited to the business’s daily running, stock, customer service, bookwork, etc).
- Choose your business name
- Register with local, state, and, if required, federal authorities
- Obtain any required permits and licenses
- Determine your tax obligations and file for registration
- Apply for the partnerships EIN
If you’re forming a partnership with another company, then all legal issues pertaining to control, what percentage, and the final say, must be agreed upon before registration. Doing so helps minimize any possible future problems.
However, if you’re going into partnership with an individual, let’s say a friend or a family member, tread carefully because you don’t want a business conflict destroying a relationship. To run a successful partnership, you must know each other’s skills, respect them, and allow both sides to do their job accordingly. And there’s the “collective goodwill”!
- Flexibility: Duties can be shared
- Reduced liability: The more people involved, the less you’re on the hook if anything goes wrong
- Increased resources: Both sides of the partnership bring resources to the business
- Taxation: Double taxation doesn’t apply due to what’s known as flow-through taxation, you only file for a single entity. The individual partners pay taxes at their taxation rate, and any losses made by the general partnership may be deducted from each member’s other sources of income
- Unlimited liability: As a general partnership, all partners are personally liable for the debts and any other obligations
- Conflict: Yep, unfortunately, where there’s a partnership there’s also disagreement
The bottom line is, you’ve got to have faith in one another, and to keep that faith, a clear and concise agreement.
Limited Liability Company (LLC)
Forming a limited liability company has its advantages, but with those advantages come responsibilities.
So, what’s the pay-off for the extra responsibility involved with setting up and running an LLC?
Let me break it down for you:
A limited liability company is a hybrid between a partnership and a corporation, its goal is to give the owners the best of both worlds.
You get the flexibility of a partnership but with the separate legal entity of a corporation (limiting your liability) in the case of debt or legal action, and if you’ve got a good accountant and the right paperwork you can avoid (at all costs!) being taxed as a corporation.
Forming an LLC
The rules for setting up an LLC will depend upon the state you’re trading in; however, the requirements are similar throughout. You don’t require legal counsel to form one, but if the LLC has multiple owners or investors, it is advisable to do so.
LLC members can choose to be treated as a partnership or as an S-corporation for income tax purposes, and single LLCs can opt to be treated as a sole proprietor.
Another tax benefit of an LLC is a “flow-through” tax arrangement, thus avoiding the C-corporation double tax payment.
- Limited liability: You have a higher level of financial protection if the company falls into debt or faces litigation. Note (As an LLC owner you can still be held liable for any debts if you stand as a guarantor for funding)
- Flexibility: All the pros of a corporation and the flexibility of a partnership
- Public perception: An LLC is often held in higher regard than a sole trader; therefore, clients can be more inclined to work with an LLC.
- Taxation: LLCs can choose to be treated as sole proprietorships or partnerships by the IRS, thus avoiding paying corporate taxes and filing the complicated corporate forms.
- Initial registration: To officially form an LLC, you must file an “Articles of Organization” with the secretary of state
- Filing fees and setting up costs: LLC filing fees and costs vary by state and can range from $100-$1000
- Minimum annual tax: Some states require you to pay a minimum yearly tax regardless of your earnings, in California this is as much as $800
- LLC Operating Agreement: Upon filing an LLC you must provide a detailed “operating agreement” containing information about management structure, finances, rights, and responsibilities
- Annual report filing: Almost all states require an LLC to file an annual report, and failing to do so can lead to late fees, penalties, suspension, and even the LLC’s dissolution
Apple, Amazon, BP, Coca-Cola, Walmart, and Alphabet Inc (Google to you and me) are all corporations.
Most of the world’s largest and influential companies are, because of the many advantages that come with forming a corporation.
A brief description:
Corporations are separate legal entities from their owners IE, the shareholders.
They’re often referred to as a “legal person” because corporations have most of the rights and responsibilities individuals possess: IE they can borrow money, enter contracts, hire employees, own assets, sue, be sued, and pay taxes.
Corporations have limited liability, meaning the shareholders can receive profits in stock appreciation and dividends while remaining non-liable for any company debts or litigations.
There are many different forms of corporations such as Non-profit, C Corporation, S Corporation, Publicly Held Corporations, Professional Corporations, Closely Held Corporations. All can trade under the corporation’s name or a separate business name (For example, Alphabet Inc trade as Google).
Forming a corporation:
The process varies between states, but regardless of which you live and trade-in, you need to file “articles of incorporation”, and issue stock to the shareholders. The number of shareholders, can also vary, anything from one person to thousands.
The setting up process, obligations, and numerous conditions make forming a corporation a complicated and expensive process that often requires a large team of legal professionals.
Taxation can be enormously cumbersome, and you can be taxed twice, once on the business revenue, and then on your personal income. Corporations are regulated under their jurisdiction of residence’s corporate laws.
- Shareholders are separate from legal liability, and therefore all personal assets are secure
- A corporation can sell stock and acquire financial capital
- Professionally ran structure with defined roles and agendas
- Employees can buy the stock at a fixed-in price, and receive payments in stock benefits
- Listing a corporation is a very time consuming and expensive process
- You will have reduced flexibility caused by the sheer weight of regulations
- Double taxation (both the corporation’s profits and owners paid dividends are taxed)
Over to you
See, I told you it wasn’t confusing.
Your first move is to decide on which type of business ownership structure is right for your business, file the required documents, and then get the correct licenses and permits.
Here’s a breakdown to help you make the right decision and avoid those sleepless nights:
A sole proprietorship is an excellent choice for first-time business owners, those working alone, with a lack of capital, or trading in a low-risk business sector but can afford the necessary insurance.
If you and another like-minded individual who both have the required skill set to turn an idea into a reality, then a partnership is a great way to go.
An LLC is an excellent choice for those who want a company that stands tall with public perception, may hire employees, and wants to retain the flexibility of a partnership/sole proprietorship while remaining as a separate legal entity.
If you’re planning on creating a large company that might raise capital by selling shares and you have the resources required to run it, a corporation is a stable foundation for long-term growth.