Determining your company’s legal structure is one of the first decisions you will face as an entrepreneur. If you do not have a business background, it might surprise you to know you have several options, each of which has different tax and capital raising consequences. Educating yourself and discussing your options with a lawyer are important parts of your decision making process.
Sole Proprietorships are the simplest, least complicated, cheapest structures to form. A Sole Proprietorship is a business that is both unincorporated and is owned and operated by only one person (that would be you!). Since your business is not a distinct legal entity, you do not file annual business taxes. Your business taxes are simply incorporated into your annual personal income tax filings. The tax rate paid on sole proprietorship earnings is often lower than that on earnings of a corporation. While this legal structure may suit independent consultants, it is not appropriate for those starting a business with one or more colleagues, or for those seeking funding from outside investors. Sole Proprietors also face unlimited liability for any debts accumulated during the life of the business.
Partnerships are unincorporated businesses operated by two or more individuals. Like Sole Proprietorships, Partnerships are not distinct legal entities. Profits and losses from a partnership are incorporated into each partner’s individual personal income taxes and are allocated in accordance with the “Articles of Partnership,” a legal contract between the parties involved. In addition to the division of profits and losses, the Articles of Partnership also determine the name of the Partnership, the date the Partnership was formed, the duration of the Partnership, and the provisions governing dispute resolution between partners. There are several drawbacks to this structure. First, Partnerships are not suited to raising investment capital. Second, partners in a Partnership face unlimited liability for the debts of the Partnership. Furthermore, if a single partner is unable to meet an obligation under the Articles of Partnership, then the remaining partners are liable for the outstanding obligation. Finally, the existence of a Partnership is limited to the physical lives of the parties responsible for the entity’s formation.
Unlike Sole Proprietorships and Partnerships, Corporations are distinct legal entities separate from their owners (shareholders) and employees. There are two types of corporations: (1) an S-Class Corporation, and (2) a C-Class Corporation. As a separate entity, a Corporation’s liabilities are not transferable to shareholders, and as a result of its independence, a Corporation can exist beyond the years of its founders so long as it remains solvent. The combination of limited liability and relative ease of transferring ownership interests make Corporations the most likely organizations to obtain outside investment. Most venture funded startup companies for example, are formed as C-Class Corporations. A major drawback of Corporations comes in the treatment of taxes. Revenues earned through this structure are subject to “double-taxation.” Employees & Shareholders are responsible for personal income taxes and taxes on dividends respectively, and the Corporation is responsible for any corporate profits.
Which of these structures should you choose?
There is no obvious answer. The type of structure you decide upon will reflect the needs of your new business. If you are starting out as an independent consultant, you might want to stick with the Sole Proprietor model. If you will be seeking venture capital, then you should structure your business as a Corporation. No matter what you do, be sure to assess the needs of your business, understand the implications of each organization type, and consult a lawyer.