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Choosing the right structure for your startup
The wrong business structure could have big implications on tax and liability. In this easy to follow guide we help you identify the best one for you.
2019. 8. 14. • 31 분 읽을 거리
업데이트 작성일: 2020. 2. 17., 작성자: Closed User
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Before you start establishing your business you need to decide on its structure
Your choice of business structure depends on the multiple variables: how many people will run the company, how much liability you're willing to put on the line, etc.
It can get quite confusing and overwhelming. The good news is that you have the option of changing your structure as your business evolves, so there's no need to worry about locking yourself into a bad decision.
Choosing the wrong business structure, however, could result in you paying a lot more taxes and risking a lot more of your assets, so you should do the best you can to select the right structure from the get-go.
In this chapter, we'll detangle the confusion of business structures and help you choose the perfect one for your startup
Types of business structures
There are 7 main types of business structures in the United States. These structures are applicable to both brick and mortar businesses and ecommerce businesses:
Sole Proprietorships
Partnerships
Limited Liability Company (LLC)
C-corp
S corp
B-corp
Nonprofit
Sole Proprietorships
A sole proprietorship is the simplest business structure. It’s the standard structure of all solopreneurs for a good reason: the setup process is very quick.
When you operate as a sole proprietor, you and your business are both one entity. This means that you share the same income as well as the same assets. This does come with some implications we'll discuss in more detail shortly.
If you're starting your business alone, a sole proprietorship is a good structure to choose. Almost all businesses begin as a sole proprietorship and then evolve intro more complex structures over time if required.
There are several reasons a business owner might choose to upgrade from a sole proprietorship:
To reduce liability and therefore mitigate risk
To increase chances of securing funding (from banks and investors)
To split a venture with other partners
To keep business tax separate from personal tax
We'll expound upon some of these reasons below:
Advantages of choosing Sole Proprietorship
There are very few setup requirements for a sole proprietorship. If you wanted to stay as lean as possible, you could run a sole proprietorship under your name only without registering a business name.
Other businesses structures require the payment of a registration fee in order to get set up. Sole proprietors, however, don't have any registrations fees (although other fees may apply).
If you run a business as a sole proprietor you don't have anyone else to answer to. No business partners. No investors. Just you and your vision.
This advantage is the main reason why business owners prefer to keep this structure. If you prefer to be the only captain steering your ship, a sole proprietorship setup is ideal.
Of all the business structures, tax returns for a sole proprietorship are the simplest to file. As a result many solopreneurs prefer to file their own tax returns, at least in the early stages of establishment before things get too complicated.
Because a sole proprietorship and its owner are considered a single entity, only one tax return is required. The only extra requirement is appending a completed schedule C form to your tax return (more details on tax further along this document).
The simplicity of sole proprietorship tax returns also means that there's no need to regularly hire auditors to assess your financial activity. This alone could save you thousands of dollars every year!
Because you're the sole owner of the business, you're free to decide on your salary. You're under no obligation to set aside a certain amount towards other areas of the business.
It is, of course, always wise to set security savings aside, but if you really wanted to you could legally take all of the after-tax profits!
If for whatever reason you decide that running a business is just not for you, as a sole proprietor you can readily dissolve your operations in just a few steps.
The steps involved in dissolving a sole proprietorship vary from state to state, but the basic requirements are as follows:
Notify the IRS
Cancel any state obligated business licenses
Pay outstanding debts (make sure you collect all money owed to you first)
Disadvantages of choosing sole proprietorship
In order for banks to offer you a loan, they need to be satisfied that you have sufficient assets to cover the value of the loan in case of any problems with repayments.
If you operate as a sole proprietor, even if you do have sufficient asset security to cover the loan, those assets are at risk of being removed if you happen to be sued without any protective measures in place.
As a result, banks would of course feel hesitant about offering a sole proprietor a loan.
The stats below illustrate the loan approval rate of sole proprietors in comparison to other business structures:
Another reason why sole proprietors might sometimes face loan approval issues is that the structure doesn’t make a clear distinction between business income and the owners income.
More complex business structures such as an LLC, formally separate business income from that of the owner. Such a formal financial structure is more appealing to banks because it conveys a greater sense of discipline with less risk of loan repayment issues.
Investors are also a lot less likely to fund a sole proprietorship because they will not receive a formal share of the company in exchange for funding.
If you decide to take on a business partner, you will not be able to formally split ownership under a sole proprietorship structure.
If you start your business with a partner, you would need to choose a partnership business structure or higher.
This inability to split equity is what prevents many sole proprietorships from securing investor funding. Investors almost always want a slice of the pie in exchange for their investment.
The main disadvantage of a sole proprietor setup is that it poses the greatest risk to your possessions (and therefore your family).
If your business is sued for any reason, all of your possessions could be taken to cover losses.
It doesn't just have to just be triggered by a lawsuit. If you ever run into issues paying your bills, your personal bank accounts and credit cards are at risk of being legally tapped into in order to cover payments.
If payment difficulties push you to file for bankruptcy, you wouldn't be able to file for it under your business only.
Since as a sole proprietor you and your business are both considered one entity, a bankruptcy status for your business would equate to a bankruptcy status for you personally too.
This high level of risk is what drives some entrepreneurs to preference a business structure without any ties to their personal assets, such as a Limited Liability Company (LLC).
But don’t let this risk scare you and prevent you from choosing a sole proprietor structure.
If sole proprietors kept getting sued and losing all of their possessions they would not be such a predominant sector of the business market:
Even though, at this stage, choosing a sole proprietorship may seem scary, there are some steps you can take to greatly reduce these risks, thereby allowing you to still reap the benefits of this business structure.
How to lower your risk as a sole proprietor
Segregate financial channels
A very simple yet effective method of demonstrating the separation of business funds from personal funds is by opening up a business bank account specifically devoted to receiving and saving business funds.
By choosing to have a separate bank account specifically for your business transactions you're demonstrating your mature fund management abilities which is a very appealing trait to financial institutions.
When choosing a business banking account, make sure you shop around for the best possible deal. Often these accounts come with some conditions, such as the number of monthly transactions, minimum opening balance, minimum monthly balance, etc.
If you want to further demonstrate the seriousness with which you'll treat your businesses funds, use accounting software to categorise all of your transactions.
Get insured
Purchasing business insurance should be a mandatory requirement for all sole proprietors.
There are different types of business insurance available, each one designed to cover a specific category of business activity.
The minimal insurance cover you should purchase as a sole proprietor depends on whether you plan to work alone or employ others to work with you.
If you plan to work alone, then the minimum insurance cover your should purchase is general liability insurance.
If you plan to employ others, the minimum amount of cover you should purchase is workers compensation insurance and general liability insurance.
General liability insurance covers any losses your clients may incur as a result of your involvement. Workers compensation insurance covers any injuries your employees may incur while working for you (slipping on site, carpal tunnel syndrome, hearing damage due to loud noises, etc).
Most states require employers to purchase workers compensation insurance before any employees are hired.
If you hire freelancers, however, you're not obligated to cover them with insurance because they're classified as self-employed.
So a great way of expanding your operations as a sole proprietor while keeping your overhead as low as possible is to hire freelancers to work for you.
Here's a list of other types of insurance you may want to purchase as a sole proprietor:
Product liability insuranceThis cover protects your from any damage or injury that may result from your products.
Disability insurance This cover is mandatory in some states. It covers employees for any injury or death, and as a result guarantees a portion of their wages to their specified recipients.
Employment practices liability insurance
Protects you from any discrimination claims by employes such as wrongful termination.
While having the right insurance does give you and your personal assets a significant amount of protection, if you want to totally remove any possibility of losing your assets, the safest option is to upgrade to a limited liability company structure (more on that later).
Always use contracts
Insurance protects you in case of a lawsuit. Contracts help prevent lawsuits from happening.
Before doing any work for anyone, make sure you both sign a contract so that both parties have a clear expectation of all duties.
A quick reference of the contract could be all that is required to quell a dispute, which will save you a tonne of money on legal costs.
If possible you should get an attorney to curate contracts for each of your client based activities, although there are services online that provide contractual templates you can edit.
An example of one such online service is offered by LawDepot.
Get an Employee Identification Number
Unless you have employees, as a sole proprietor you are not required to have an employee identification number (EIN), but it's still a good idea to get one for security reasons.
Not only does an EIN make your business seem more established, but also, in some rare cases, you could apply for a bank loan using just your EIN, without needing to provide your social security number.
Should you choose a sole proprietor business structure?
If you are starting out alone and want to start transacting as a business ASAP, a sole proprietorship is a great structure to begin with.
As mentioned, you can always upgrade structures as your business expands. Just make sure you purchase the appropriate insurance policies to protect you and your assets.
Taxation forms for sole proprietorship
Sole proprietors need to outline all of their profits and losses in the Schedule C form that can be accessed here.
They also need to fill out a standard form 1040, which can be accessed here.
More information on the taxation obligations of sole properties can be read on the IRS website by clicking here.
How to start a sole proprietor business
The process of starting a sole proprietorship differs from state to state, so you'll need to do a bit of research on your state's specific requirements.
Below is a general overview of starting a sole proprietorship business:
Get an EIN
If you'll be paying employees you need to have an employee identification number (EIN). It’s absolutely free to obtain one, so if a 3rd party is offering to get you one for a fee, it’s most probably a scam you should steer clear of.
For instructions from the IRS on applying for an EIN click here .
For an outline on how to legally operate a business with employees click here .
Obtain relevant licenses and permits
Not all business operations are permitted in every location. Even if you plan to run your business from home, your local zoning may only permit certain types of activities.
For a list of federal licenses and permits from the United States Business Administration click here.
For information about the zoning laws of your location click here.
Register a business name
If you choose to operate your sole proprietorship under your full name, you can skip this step.
If, however, you prefer to operate under an official business name, you will need to register it so that you can legally run your business under that name.
Registering your business name also prevents anyone else from claiming it.
For details on how to register a business name click here.
If you want to take things a step further and own the legal rights to the name, you can trademark it.
For information on how to trademark your business name click here.
Partnership structure
If you want to start a business with one or more partners, a business partnership is the simplest business structure that can accommodate this.
The structure of a partnership is very similar to that of a sole proprietor in that you don't have a separate tax return and you have free access to all the after tax profits.
In a partnership, each partner’s personal assets are also tied to the business, but the level of liability of each partner depends on how much of the business they own.
So the partners with the least percentage of ownership have the least liability risk.
General partnership
A general partnership structure equally distributes the unlimited liability of the business across all members.
So each member is equally liable for any loss and damage as they would be in a sole proprietorship scenario.
Limited liability partnership
In a limited liability partnership, the personal assets of business owners are protected from business responsibilities.
What to include in your partnership agreement
The partnership agreement is the most important document you will need to create when formulating a partnership structure.
The partnership agreement is a formal agreement amongst all parties of how the business will be run and the percentage of ownership of each partner.
It is important to have all of these details clearly laid out for all partners to agree on before any business operations are undertaken.
If any conflicts arise between you and your partners, you will have this partnership to refer to as an objective source of truth.
The structure of your agreement is entirely up to you. There are, however, some important details we recommend you include in your business partnership agreement to cover all the bases of a possible conflict.
In order for your agreement to have relevant authority, you need to specify in the title who is bound to the agreement.
If your business is operating under a fictitious name, then the name of the business should be used.
For example, “prestige motors partnership agreement”
If you will not be operating under a fictitious business name, all the names of all parties involved should be specified in the title.
For example, the title “Smith and Wesson partnership agreement” is an aggregate of the surnames of the two parties involved in this partnership.
Specify how much of the business each partner owns. The percentage can be determined by the amount each partner invests into business, or by the level of contribution each person has committed to.
The ownership percentage will govern the distribution of profits amongst members, this is something you need to clearly outline in your agreement.
In this section you can also specify the liability status of each member (general or limited).
Even though this may cause a bit of a content overlap with the division of ownership section, it is important to have a section in your agreement specifically devoted to outlining the key responsibilities of each party.
All partners are limited to their outlined responsibilities. They can help in other areas too. Think of these responsibilities as what is least expected of all parties.
The method of settling on a final decision should be clearly defined in your partnership agreement.
Maybe the individual with the majority ownership of the business will make the final decision for the company.
Or perhaps a unanimous agreement amongst all members will be required before a final decision is made.
Whatever you decide your decision making process to be, each member should be satisfied with it prior to signing the document.
Whenever multiple parties are gathered together for considerable lengths of time, disputes are likely to occur, especially when it comes to establishing a business.
In order to keep all disputes civilised (and minimal), you should stipulate a mediation clause.
The method of resolution depends upon what works best for everyone. Maybe you can nominate a professional third party to formally mediate your disputes for you.
The end goal of a mediation clause it to prevent any disputes escalating to a court case.
This possibility should highlight the integral importance of only choosing business partners that work well together in all circumstances.
So choose your partners wisely from the very start!
For a helpful video about how to choose the right business partner Click Here
In order for anyone to sign an agreement on behalf of a business, they need to have the appropriate level of binding authority assigned to them.
This is probably one of the most crucial elements you need to make crystal clear in your partnership agreement - who has the right to officially represent the business?
If an individual with poor judgment is given binding authority, they can agree to sign up for a loan or service that may not be in the best interest of the business.
Once a 3rd party contract is signed it cannot be revoked outside of its terms and conditions, so take each member of your partnership into careful consideration when deciding whether they should be granted binding authority.
Specify terms to outline the appropriate process of executing the signing of 3rd party contracts and agreements.
You need a plan in place should any of your partners withdraw from the business either voluntarily or due to unforeseen circumstances such as death.
A buy and sell agreement is commonly put in place to settle such circumstances. The purpose of this agreement is to protect company shares from being sold to 3rd parties.
Usually, upon the withdrawal of a business partner, their portion of the shares are sold back into the business to keep all ownership distributed between the original remaining partners.
When curating your death and withdrawal clause, make sure you keep the business’ best interests in mind. Also keep it as clear and concise as possible. Following this procedure during such tough circumstances should be a straightforward process.
An important attribute of a partnership to keep in mind is that if any of its members pass away or withdraw, the business usually ends almost immediately. This is the downside of operating an entity that is inseparable from its members.
The same applies to sole propiertorships.
If this occurs, a new partnership would need to be formed comprising the updated list of members.
Advantages of a partnership structure
If you're planning to start a business with multiple parties it may be tempting to settle with a partnership structure due to its simplicity. Make sure you read through the points below before making a decision:
Just like a sole proprietorship, partnership structures are reasonably quick to implement. There's a lot less paperwork involved compared to other, more complex structures.
The only document that will demand a majority of your time is the partnership agreement.
Just like a sole proprietorship, a business partnership structure, all parties have access to as much of the business profits as they please, within their designated percentage share.
But just like with sole proprietorships, it's always a good idea to be conserviative when accessing profits by keeping the business savings account as hearty as possible.
In a partnership structure, each member bears the burden of any losses and debts that the business may encounter.