Which Business Entity Structure Is Best for You?
The Pros and Cons of Each
Are you planning to plunge all your efforts in the business world? Most of us want or rather aspire to own huge business enterprises that command good reputation. We all dream to make millions of dollars without having to go for a bank loan. One of the avenues that give each of us an opportunity to make generous profits is entrepreneurship which involves setting up a different legal entity structure depending on one's interests.
Although this could be true, it is not given! The type of business legal structure you choose can either make or break you. How? This is because different business structures have different ways of operation, different burdens when it comes to payment of taxes and different liabilities. Therefore, before going ahead and risking your hard earned money, you need to understand different business entities and their pros and cons in order to determine which one suits your interests.
According to experts, this is one of the simplest forms of business organizations one can ever have. It is a business formed, managed and controlled by one person who is the owner. The business and the owner are the same thing. When you form this type of business, you are your own consultant, you are the decision maker and all the losses and profits come to you. They include canteens, restaurants, simple shops and boutiques.
For this meaning to stand, the business should not have branches in other areas.
Pros of Sole Proprietorship
The owner enjoys all the profits of the business: since it is owned by a single person, he enjoys all the profits that the business accrues.
- Quick Decision Making: When it comes to making decisions about changing the type or quantity of commodities that the business deals in, you do not have to consult anyone.
- Easy to Manage: As a single business owner, it easy to manage your business since there is no bureaucracy that you have to follow when making decisions.
- Flexibility: This applies in terms of changing the commodities that you sell. You can change them anytime you feel like as long as it is a general sole proprietorship with freedom to sell any product.
- Easy to Start: Yes, this business type does not have very long legal procedures to follow before it gets established.
Cons of Sole Proprietorship
- The owner incurs all the losses: In case of losses, the sole proprietor bares all the burden solely.
- Unlimited liability: This means that in case the business runs bankrupt, the assets of the business owner will be sold to clear off the debts.
- The business owner pays personal income taxes on the business net profits.
A partnership is a type of business entity owned and operated by two or more individuals. The partners contribute money in order to raise the required capital so as to start the business. All of them are responsible for how the business operates and take part in decision-making. At times, the partners might decide to allocate each of them a different role so as to enhance the efficiency and performance of the entity.
If you would like to start a general partnership, have a look at the pros and cons.
- Easy to Start: Forming a general partnership usually takes a short time since it does not involve long legal procedures.
- Requires less capital: The amount required to start off a partnership is not equal to the amount you need to start a company. The amount of profits are shared according to the ratio of capital contribution of each partner. The higher the capital you contributed, the more the profits you enjoy.
- Consultation: The good thing with partnerships is that before arriving at a final decision, there is always consultation between the partners. This leads to better decisions that improve the business.
- Quick Decision Making: A partnership owned and operated by two people is easy to make decisions that can enhance the performance of the business. You don't need to call a meeting to discuss arising issues, just a phone call is enough.
- Unlimited liability: General partnerships means that all the partners have unlimited liability. In case of business debts that the business is unable to pay, the personal assets of the partners are at risk of getting sold in order to clear off the debt.
- Internal Wrangles: Sometimes many partnerships do fail because of internal conflicts or personal interests of a certain partner. The partners have a burden of paying personal income taxes on the net profits of the business.
Limited Liability Partnership (LLP)
A limited type of partnership is whereby all the individuals have limited liability unlike in general partnerships where all partners have unlimited liability. A partnership operates as a limited type only after the partners file an application of registration with the secretary of state. These types of partnerships used to be limited to professional services such as lawyers, accountants or doctors.
However, nowadays even common businesses may apply for registration for as long as the partnership has partners that run and operate the business and partners who act as investors. Those running the business have unlimited liability while the investors have limited liability.
Pros of LLP
- A partner is not liable for any wrongful acts of other partners. Each partner carries their own burden and face consequences of wrongdoings individually.
- The formation procedure is not long: When you want to create a limited partnership, it is not tiresome since it only needs approval by the secretary of state.
- Quick Decision Making: A limited partnership has a few partners which makes consultation easier and quicker.
- There is room for consultation: Two heads are better than one that's what they say. Partners have a room for discussion before making the final decision. This improves the quality of business decisions made. Partners with limited partnership can leave anytime without dissolving the partnership.
- They are more expensive to form than general partnerships.
- Affected by personal interests: Most of the times what leads to dissolving partnerships is disagreements between individual partners.
- Partners with unlimited liability (those in managerial positions) suffer whenever the business is unable to pay off its debts.
This is a business entity owned by a list of shareholders. The shareholders have the mandate to elect a board of directors whose work is to oversee the day to day running of the corporation. When it comes to decision making, it is the responsibility of the directors to make sure that any decision made benefits the corporation and is in support of the corporation's objectives. Also, the directors have the power to hire and fire employees. The employees of the corporation have the obligation to make sure that the targets of the business are met within a certain duration of time.
A corporation operates as a separate legal entity from the owners. This means that the owners have limited liability. As a separate legal entity, it means it can buy real estate, sue and even get sued by creditors. An established corp can raise capital via sale of stock in the stock market. Its ownership can also be transferred from one party to another. It also has perpetual existence meaning that it can continue operating even if the ownership changes.
When you want to start a corporation, most probably you will be the major shareholder with authority to appoint directors. The directors will then go ahead to hire employees that will be responsible for the running of the company. A corporation operates under what is termed as corporation by-laws. This is a set of document that provides guidelines on how the corporation should operate. These by-laws can be modified as the company grows. Every year, the corporation should hold an annual meeting to discuss how the entity has performed.
- One of the most attractive things about a corporation is that the owners have limited liability. This means that in case of debts, the assets of the owners are very safe and remains untouched by the creditors.
- There is a possibility to lower taxes especially when the owner and the business share profits.
- At certain times, benefits may be deducted as business expenses.
- The ownership of a corporation is easily transferable. This means that in an event whereby the current shareholders and directors foresee a dark future, they might sell the corporation and hence avoid losing their capital investment.
- It is very expensive compared to setting up simple business setups such as sole proprietorship and partnerships.
- Starting a corporation involves a lot of paperwork. When it comes to legal paperwork, the owner must file it with the secretary of state.
- A corporation operates as a separate legal entity and hence is entitled to pay taxes.
- There is slow decision making in corporations since the directors have to be consulted before any verdict is reached.
The difference between an s corp and a c corp is based on the taxation process. When it comes to an s corp, there is only one level of taxation. The income generated by the corporation is distributed among the shareholders for taxation purposes. However, with corps, there is double taxation. The corporate pays corporate tax on its own as a corporate while the dividends generated by the company and passed down to shareholders are also taxed in terms of personal income tax.
Pros of an S Corporation
Before you take a step and register your business as an s corporation, you should beware of both the merits and demerits it comes with. The merits include:
- Single layer of taxation: The shareholders of s corporation escape double taxation since the taxes are only payable at the shareholder's level and not at the corporate level. While the business' income continues to be taxable, the shareholders do not carry any extra burden when it comes to tax liability.
- Step up in Basis: Depending on the amount retained each year by the corporation as income, the shareholders receive a step up on the basis on their stock. This reduces tax liability on the shareholders especially when the shares are ever sold.
Cons of an S Corporation
- Cash flow vs tax liability: Whether the shareholders get their share of dividends or not, they are expected to pay their pro rata share of taxes on the company's earnings. This means that a corporation needs to have proper management of cash flow to avoid any inconveniences in this area.
- Built-in Gains: When an asset of an s corporation is sold within 10 year period of s corporation election, then the gain based on the value of the conversion date is taxable to the company. This means that for a corporation which is growing, it is advisable to convert sooner than later in order to minimize the amount gains within a 10 year period.
Limited Liability Company (LLC)
This is a hybrid of both a corporation and a partnership. A limited liability company operates as a separate legal entity and hence has exclusive rights to buy and own assets, sue or be sued. It has a pass through taxation feature just like a corporation. This means that the members ( shareholders) only suffer from a single taxation just like in a partnership. Unlike a corporation, it has no stock and does involve fewer formalities during the formation process.
The owners of an LLC are called members and not shareholders like in a corporation. This has made many people refer to it as a corporation with fewer complications. This type of company operates under a set guideline of rules referred to as 'operating agreement'. These set of rules can be modified depending on how the business performs over a certain time duration. Operating a limited liability company is less complex since it only requires the members to meet once or twice a year to make or implement certain decisions.
Pros of LLC
- Single Taxation. An LLC does not pay taxes at the company level. The taxes charged are ones that are passed through to the members who later pay personal income tax.
- Liability protection for members: The members of an LLC have limited liability meaning that their assets cannot be taken away to cater for business debts.
- They are easier to establish compared to corporations since little paperwork is involved.
Cons of LLC
- They require more capital in order to establish compared to sole proprietorships or partnerships.
- They require more paperwork and legal procedure.
Thus, establishing a business entity structure requires an entrepreneur to consider these things, the amount of capital, the type of liability and how easy it is for them to be formed. This is the guideline that one has to follow before deciding a business entity for themselves.