Starting a Small Business: Which Legal Structure Should You Choose?
KEY POINTS
There is a legal structure made for your situation. We will explore the three main types: sole proprietorship, partnership, and corporation.
Personal liability is a critical concern when choosing a legal structure
The structure you choose will dictate many aspects of how profits are taxed
Where to Start When Starting a Small Business?
Starting a small business can be simultaneously exciting and scary. The process can be overwhelming as you try to manage financing, marketing, advertising, social media, sales, purchasing, human resources, operations, inventory, legal, accounting, technology, and the list goes on.
Today, we will focus on one key aspect of starting a small business:
Choosing a Legal Structure
This may not seem like an exciting topic, but it is one of the first things you will need to do. Your decision on legal structure will have a significant impact on:
Day-to-day operations
Degree of personal liability risk
Ability to raise additional capital
Ability to obtain financing
Taxation
Administrative burden
You need to make the correct decision the first time.
Business structures can be changed in the future. However, such may face governmental restrictions, negative tax consequences, unintended dissolutions, costly professional advisory fees, excessive administrative burden, among other issues.
Starting a Small Business – What are the Options?
Sole Proprietorship
Your business venture is considered a sole proprietorship if it is not formally registered as any other kind of business (e.g., partnership, corporation). It is an informal option and it is easy to establish.
Your business assets and liabilities are not legally separate from your personal assets and liabilities. Therefore, you can be held personally liable for the debts and obligations of your business.
It will not be possible to raise investment capital as there is no structure for third parties to invest in. Your ability to obtain financing will be based solely on your personal financial situation and banks may be hesitant to lend to you as a sole proprietor.
Business income and expenses will need to be reported when filing your personal tax return and such income will be subject to your marginal tax rates. Business losses may be offset against income gained from other sources, limitations and restrictions apply.
Partnership
A partnership consists of two or more individuals that own a business together. Each partner contributes money, property, labor, skill, and expertise in exchange for a share of the profits generated by the business.
A partnership agreement is not legally required; however, we highly recommend you explore this option with your professional advisors. A well designed agreement can lay the foundation for how your business will operate and provide guidance on potential future events (e.g., partner exiting the partnership, death of a partner). In the absence of a partnership agreement, your operations may be subject to undesirable government regulation.
There are three primary types of partnerships: limited partnerships (“LP”), limited liability partnerships (“LLP”), and general partnerships (“GP”). Your degree of personal liability risk is dependent upon what kind of partner you are.
LPs consist of one general partner and multiple limited partners. The general partner manages the LP and has unlimited liability. The limited partners have minimal control of the LP and have limited liability up to the value of their respective investments in the LP.
LLPs consist of multiple limited partners. Each partner has limited liability against the debts and obligations of the LLP as well as actions of the other limited partners. The LLP structure is often utilized for professional services companies (e.g., law firm, accounting firm).
GPs consist of multiple partners that share in the operations, profits, and liability of the GP.
Partnerships can raise capital from existing partners or by admitting new partners. They can also obtain business loans and lines of credit.
Partnerships are referred to as “pass through” entities from a tax perspective. Their income and losses are allocated to each partner (usually as per a partnership agreement) and each partner is responsible for reporting their allocated income on their tax return. The income and losses maintain their nature (e.g., dividends, interest) as they are passed through to the individual partners.
Corporation
The legal formation of a corporation involves many steps including the issuance of shares and the appointment of directors and officers. When starting a new business, the founding shareholders often assume roles as directors and officers.
Shareholders have a higher level of protection from legal liability as the corporation is a separate legal entity from its owners. Directors and officers are generally protected from personal liability. Directors and Officers liability insurance can be purchased to protect the individuals from personal loss if they are sued in connection with serving as a director or officer of the corporation.
Corporations can raise capital by issuing additional shares. The ability to issue shares can also attract future employees. Corporations can also obtain business loans and lines of credit.
When starting a small business, a bank may not extend financing based on the company’s limited operating history. The bank may require the shareholders to personally guarantee such loans. The shareholders would face legal liability with respect to such financing.
A corporation is recognized as a separate taxable entity and must file an annual tax return. Profits are taxed as earned. Shareholders are taxed on dividends, if any, when received from the corporation.
How do You Choose?
The first step is to read articles like this one to better understand the available options and how each may apply to your situation. The ultimate decision is complex as it involves taxation, legal liability, capital financing, and many other integrated areas requiring expertise.
When starting a new business, we highly recommend that you obtain professional advice from your advisory team. A designated accountant and / or a corporate lawyer should be able to guide you towards the structure best suited for your needs.
To that end, we invite you to read our post Financial Advisors for the 99% and How to Choose a Financial Advisor - A Definitive Guide to ensure you choose advisors that are well aligned with your financial plan.
Good luck on your new venture!
