One of the first steps before starting a business is choosing the right business entity. Among other things, it makes sure that the entrepreneur is able to reduce the level of taxes, works on checking liability exposure and can be self-sustainable as far as financing in the later stage is concerned. A right business entity also ensures that the owners have a mechanism wherein the business continues to flourish in case of death of one or more owners.
While finalizing a business, one should keep the following factors in mind:
- The degree at which the personal assets of the owners are at risk from liabilities arising from the business.
- The best ways to ensure tax advantages and avoid multi-layered taxation
- The ability to lure investors
- Cost of operating the business, which should be minimal
- Also the ability to ensure, if the need arises, that the ownership interests are easily transferred to key employees
Apart from keeping these essential factors in mind, one must also note that whatever choices are made regarding the entity are going to fluctuate during the due course of time. The nature of business remains the same but there are various factors like the market and government policies which impact the business in the longer run.
The number of owners defines the entity type of the business. While a single owner can operate as a sole proprietor, a corporation, or a limited liability company but the moment there is more than one owner involved, in legal terms, it cannot be called sole proprietorship. However, it can be a corporation, limited liability company, general partnership, a limited partnership. In certain situations, it can even be a limited liability partnership.
Lets now discuss in detail the entities:
If a business owned by a single individual it is termed as sole. It does not require any legal distinction from the owner, and also, in most cases does not need any governmental filing except a fictitious business name statement, if the owner is doing business in any name other than a personal name. It is the most common form of business as it is simple to start and is free from huge operating expenses that are needed when a person thinks of starting other legal entities such as corporations and limited liability companies. Since there is no legal distinction between the owner and the business, a sole proprietor is always liable for all the debts and obligations of the business. Also upon the death of the owner, the business ceases to exist. The physical assets of the business such as equipment, accounts receivable, and real property remains intact but even those, apart from the business, become tough to sale. One of the major boosts for a sole proprietorship business is that it does not have to go through multiple layers of taxation. As mentioned already, there is no distinction between the owner and the business so all the income of the business can be only taxed once in the category of the personal tax return.
When it comes to corporations, it is always treated as a separate entity from its owners for all legal and taxation purposes. Normally it comprises of shareholders, directors, and officers. It is the prerogative of the shareholders to elect the board of the directors, who then are responsible for setting the agenda and taking major decisions for the company. The board of directors also appoint officers who oversee the day to day affairs of the company. Also, it is obvious that the corporation is a separate entity hence all the debts and obligations of the business are not directly related to the owners. Apart from these, there are various other benefits of a corporation.
- Shares of the company may be sold to investors in order to raise capital.
- Internal revenue code also ensures that the Corporation can have pension plans, medical payment plans, group life and accident plans, and various other benefits.
- The corporation if for eternity as long as it abides by the set of corporate. Hence even if an owner, shareholder or a member of the board of director dies, it won't cease operations.
A limited liability company, or LLC as it is popularly known as is formed by one or more owners, called members. An LLP company ensures limited liability protection to its members. In LLP, limited protection of the personal assets of the members is ensured much like shareholders incorporation.
Partnership in business
When the business has more than one owner, there are basically two types of entities possible - a general partnership or a limited partnership.
General partnership in simple terms is an association of two or more persons carrying on a business venture as co-owners for profit. After a sole proprietorship, a general partnership is thought to be the easiest entity. Under most state laws, a formal written partnership agreement is not needed in case of general partnership for the partnership but it is expected that the partners keep the rights and duties ready before they embark upon the business journey. If the partners do not have a written agreement, it will be a little difficult to do the business and share the profit and losses of the business.
In a general partnership, each partner has personal liability and the business is pretty much limited when it comes to luring the investors, also it is difficult to resale such businesses. The biggest advantage of a general partnership is that there is no provision of taxing it. In fact, the losses and profits are shared by the partners according to the written document which was formed at the beginning of the forging of the partnership. Since there are less no of partners in most cases and no shareholders or board of directors, the team can always sit together and finalize or change a plan on how to make a profit or take the company forward.
When it comes to a limited partnership, it requires a written partnership agreement. Also, a certificate of limited partnership needs to be filed in the state where the partnership is formed. Hence a limited generally costs more than a general partnership. Under normal circumstances, only licensed professionals are allowed to form limited liability partnership and it is the prerogative of the state to decide on licensing.
So how do you decide on which is the best form of partnership? Before deciding on the business, here are the questions you need to answer.
- Who is going to own the business?
- What are the plans on distributing the profit among the owners?
- Is the business expected to generate profit at the start or will it incur losses?
In those cases where the owner is a single individual and is not willing to add ownership interest, then he should not be concerned about the management structure and he can opt for any business entity. Hence the decision will be taken on the basis on the kind of taxation the owner wants to have for his company.