Startup founders and other entrepreneurs have many issues to consider beyond just their core product. One issue that needs to be tackled early is your business structure. Though it may be tempting to just focus on perfecting your product and getting it to market, your choice of structure will have a major effect on factors that may mean the difference between success and failure.
There are many different types of business structure that you can employ depending on where you are. These are some of the most common ones you may encounter in the US, though many jurisdictions have similar types of business structure. Regardless of where you decide to set up your business, the structures all have their various advantages in terms of issues such as liability, control, tax burden, and the required formalities.
Sole proprietorship/sole trader
The first and most simple business structure is the sole proprietorship or sole trader. As the name implies, this business structure is for single owner businesses. Generally there is unlimited direct liability for losses and debts and this liability may attach to the owner’s personal assets. By the same token, all profits go directly to the owner and there is no tax on the company level. This is in contrast to other business structures, where profits are taxed at the company level and again when the profits flow to the individual owner.
Finally, there are little to no formalities in many countries. In some jurisdictions, it may be as simple as a registration informing the government that you intend to be self-employed.
A general partnership is a business structure that involves two or more owners. A general partnership in most jurisdictions involve joint ownership (meaning that ownership is shared equally among all partners) and all partners are entitled to an equal share of the profits. Similarly, the partners have equal control unless there is a contract otherwise. In the US, taxes are also passed through to the partners without taxation of the partnership, though the partnership has to file a tax return.
In a general partnership, the partners have joint and several liability, which means that anyone with a claim can sue any one partner for the entire amount and that partner would be liable, though he or she may try to recover it from the others.
Formalities are generally fairly simple, and in fact for a general partnership an agreement is not required in the US, though it is strongly recommended that you have one.
A limited partnership is similar to a general partnership, but allows for both general partners, who have unlimited liability, and limited partners whose liability is limited to the amount of their investment. A limited partnership must have at least one of each type of partner. Except for a few specific exceptions such as acting as a contractor or an advisor to the general partners, the limited partners generally may not participate in the business- otherwise he or she will become a general partner with full liability.
With the exception of some additional formality requirements and some taxation treatment subtleties, limited partnerships are otherwise similar to general partnerships.
Unlike the other business structure types we have discussed thus far, a corporation is a distinct legal person. It consists of a board of directors which manages the business, officers which manage the day to day operations, and shareholders who can vote to elect and fire the board and on certain topics as in whether to merge with another company. Liability is limited, but directors, officers and shareholders may be personally liable if a plaintiff can show that the corporation was basically a sham. This is usually proven by showing that there was no true separation between the corporation and the owners (for example, if the officers intermingled their personal funds in the same bank accounts as the corporations), if there was fraud, or if the corporation did not follow the required formalities.
Corporations are also subject to double taxation. Profits are taxed at the corporate level, and again if the profits are distributed to shareholders via a dividend. Also, of all the structures we’ve discussed thus far, corporations have the most formalities and rules, such as voting requirements. They are thus the most expensive to set up.
Just a taste
These are just some of the basic business structures you may find. In the US, you will also encounter various forms that combine the benefits of several of these structures such as S-corporations, limited liability partnerships, and limited liability partnerships. Other countries may also have different structures, and in fact, even within the US, the different states have different laws which may affect how each structure works.
Most importantly, there is no one-size fits all solution; the solution for you depends on your business goals and where you are doing business. Before you make your choice, the most important thing to do is to consult with legal professionals who can work with you on setting up your business and discuss with you the important issues, including some of the ones we’ve highlighted today such as liability and taxation.