Which business structure is best?
“Which business structure should I choose?” Is probably the most common question I receive from entrepreneurs.
This is sort of a trick question, as there is not one answer that suits everyone. Depending on your personal financial circumstances and the type of business you are operating, the answer might differ. Each business is different, and each business owner has different circumstances surrounding starting their business. It is not a ‘one size fits all’ situation, so I will take you through some common business structures and the advantages and disadvantages of each.
I hope this will be helpful to you as you consider this important decision for your business. If this information raises more questions for you, I have a community for entrepreneurs where I can address your specific questions.
Sole Proprietorship, Partnership or a Corporation?
Before we get into the advantages and disadvantages of each type of business structure, it is important to first understand the various types of business structures that exist. When it comes to starting a business, there are several different legal structures to choose from. Three common types of business structures that i will be covering here are sole proprietorships, partnerships, and corporations.
A sole proprietorship is a business which is owned and operated by one individual. This is the simplest and most common form of business ownership. In a sole proprietorship, the owner is personally responsible for all aspects of the business, including any debts or legal issues that arise. While this structure offers the most flexibility and control, it also comes with the greatest amount of personal risk.
A partnership is a business that is owned and operated by two or more individuals. In a partnership, each partner contributes money, property, labour/skills, and shares in the profits and losses of the business. Partnerships can be formed as general partnerships, where all partners are equally responsible for the business, or as limited partnerships, where some partners have limited liability.
A corporation is a legal entity that is separate from its owners. In a corporation, ownership is divided into shares of stock, which can be bought and sold by shareholders. The corporation is managed by a board of directors, who are elected by the shareholders. In a small corporation, the owners are referred to as shareholders and may also be involved in the day-to-day operations of the business, depending on their level of ownership and the company’s needs. One of the key advantages of a corporation is that it offers limited liability protection to its shareholders, meaning that their personal assets are not at risk if the business incurs debt or legal issues. However, corporations are also subject to more complex tax and regulatory requirements than other types of businesses.
Understanding Sole Proprietorships
The most common business structure for new business owners is Sole Proprietorship. As the name suggests, this type of business is owned by one person. This is the most straightforward type of business to form, as the business essentially becomes an extension of you as a person from a legal standpoint. Because of this, your business activities are filed on your personal tax return.
Even though there is no separation between you and your business from a legal and liability standpoint, it is important that you open separate bank accounts and credit cards for your business, to keep your business and personal financial activity separate.
Advantages of Sole Proprietorships
Easy to start: Sole Proprietorships are the simplest form of business to start. Many owners operate this type of business under their own name.
(For Canadians: Please refer to this page to find out the registration requirements for your business depending on which province in Canada you are in.)
Complete control: As a sole proprietor, you have complete control over your business. You make all of the decisions and don't need to consult with anyone else before making decisions about your business.
Minimal legal requirements: There are few legal requirements for operating a sole proprietorship. You only need to obtain any necessary licenses and permits for your business activities.
No corporate taxes: As a sole proprietor, you don't need to file a separate tax return for your business. Instead, your business income and expenses are reported on your personal tax return. (I cannot stress enough how important it is that you keep your business and personal financial activity separate even though they will be reported on the same tax return!)
Disadvantages of Sole Proprietorships
Unlimited personal liability: As a sole proprietor, there is no legal separation between you and your business. This means that you are personally responsible for all of the debts and obligations of the business. If your business is sued or goes bankrupt, your personal assets could be at risk.
Limited access to capital: It can be difficult for sole proprietors to access financing or capital because they can't issue stock or sell ownership shares in the business. Banks and investors may also be hesitant to lend money to a business that is completely owned and operated by one person.
Limited growth potential: Sole proprietorships are often limited in their ability to grow and expand because of their small size and lack of access to capital.
Is a Partnership Right for You?
A Partnership, again as its name suggests, is a business started by two or more people. As is the case for sole proprietors, the partnership is an extension of the owners from a legal standpoint. Similar to a sole proprietorship, the business activities are filed on the partners’ individual tax returns, in the proportion outlined in the partnership agreement.
It is essential that you enter into a partnership agreement prior to starting the business. Ideally, this agreement would be created with the assistance of a lawyer. You must be very careful when entering into a business partnership with someone else. I have observed that nothing seems to split family and friends quite like disputes over money. If the business is prosperous, the profits will be shared between partners in accordance with their agreement. However, if the business is struggling, the liabilities of the business are also shared. If the personal financial situation of each partner varies significantly, this can put a disproportionate amount of pressure and stress on the partners.
(For Canadians: Please refer to this page to find out the registration requirements for your business depending on which province in Canada you are in.)
Advantages of Partnerships
Shared responsibility and workload: Partners can share the responsibilities and workload of the business, which can reduce the burden on any one individual and allow for a more efficient use of resources.
Shared financial resources: A partnership has more than one person to contribute financially to the business, which can help the business secure more capital than a sole proprietorship.
Complementary skills and expertise: Partners can bring different skills and areas of expertise to the business, which can help the business grow and succeed in ways that might not be possible for a sole proprietorship.
Shared risk: The risk of the business is shared among the partners, which can reduce the financial burden on any one individual.
Disadvantages of Partnerships
Unlimited liability: Each partner is personally liable for the debts and obligations of the business, which means that their personal assets could be at risk if the business fails.
Potential for disagreements: Partners may have different ideas or goals for the business, which can lead to disagreements and conflict.
Joint and several liability: Partners may be held responsible for the actions of their partners, which means that one partner's actions could negatively impact the other partners.
Some professionals such as lawyers or accountants can enter into Limited Liability Partnerships (LLP) which combine the flexibility of a partnership with the liability protection of a Corporation.
Sharing profits: Partners must share the profits (and losses!) of the business, which can lead to disagreements over the distribution of funds and responsibility for financial liabilities of the business. How the profits and losses will be shared should be outlined in the partnership agreement to avoid issues in this area.
Should you incorporate Your Business?
The next type of business structure is a corporation. You can start a corporation “from scratch”, or you can incorporate an existing sole proprietorship or partnership. The main criteria differentiating a corporation from the previous two business structures is that it is a separate legal entity. Because of this, the corporation files its own tax return separate from that of its owner(s).
During the incorporation process, the ownership of the business is separated into shares and the owner(s) become “shareholders”. These shares can either be privately held by the owners of the corporation or publicly held if the corporation has its shares traded on a public stock exchange. I will go through the advantages and disadvantages of each.
Advantages of Private Corporations
Limited Liability: One of the most significant advantages of a private corporation is liability protection. The owners of a private corporation are not personally liable for the company's debts and legal obligations. Instead, the corporation itself is responsible for these obligations. Because it is a separate legal entity, the corporation can enter contracts and therefore “sue and be sued”.
Tax Benefits: Private corporations can take advantage of various tax benefits, including lower tax rates, the ability to write off certain expenses, and the ability to retain earnings within the corporation. Your ability to reduce taxes will depend on how much of the corporation’s earnings are retained in the business compared to withdrawn by the owners.
Capital Formation: Private corporations can raise capital by issuing shares of stock to investors. This allows them to raise money for growth and expansion without taking on debt.
Disadvantages of Private Corporations
Cost and Complexity: Setting up a private corporation can be expensive and time-consuming, requiring legal and accounting expertise. In addition, there are ongoing compliance requirements, such as annual filings, that can add to the administrative burden and cost.
Limited Control: In the case of multiple owners, there can be conflicts over management decisions and control of the business.
Less Privacy: Private corporations are required to file annual reports and other documents with the government, which can reduce privacy for the owners. A corporation can also be subject to increased government regulations and oversight.
Taking your Corporation Public
The final business structure I am going to outline is the Public Corporation. An Initial Public Offering (IPO) is the process by which a private corporation “goes public”. This means that the shares of the corporation, which had previously been privately held by the shareholders become available to the public on a stock exchange.
Once a business has gone public, its share price fluctuates based on the real – or perceived – value of the business. The main motivator for a business to go public is to raise capital for expansion of the business, or so that the business can remain operational if there are cash flow issues.
Advantages of Public Corporations
Access to Capital: Public corporations can raise capital by selling shares of stock to the public, allowing them to finance growth and expand their operations.
Increased Public Visibility: Being publicly traded can provide increased visibility and brand recognition, which can lead to more customers, investors, and business opportunities.
Limited Liability: Shareholders are not personally liable for the company's debts or legal issues, as the corporation is a separate legal entity.
Professional Management: Public corporations often have professional management teams with experience in their industry, which can improve the company's performance and decision-making.
Disadvantages of Public Corporations
Shareholder Pressure: Public corporations are owned by shareholders who have the right to vote on major decisions, such as mergers, acquisitions, and leadership changes. This can create pressure for short-term results and may limit the company's ability to pursue long-term goals.
Regulatory Compliance: Public corporations must comply with strict financial reporting and disclosure requirements, as well as other regulations, which can be time-consuming and costly.
Loss of Control: When a company goes public, the founders and management team may lose control over key decisions, as shareholders have the right to vote on major issues.
Public Scrutiny: Public corporations are subject to public scrutiny, including from the media, which can create negative publicity and damage the company's reputation.
It's worth noting that the advantages and disadvantages of public corporations can vary depending on the country and legal system in which they operate. For example, in the United States, public corporations are subject to the Sarbanes-Oxley Act, which imposes additional regulations and requirements on companies. In Canada, public corporations are subject to securities regulations administered by the Canadian Securities Administrators.
Final thoughts to consider
As I previously mentioned, when you have a sole proprietorship or a partnership rather than a corporation, the business is an extension of you personally. This means should something go wrong; it can affect your personal assets. An example of this would be if you enter a contract with a customer to hold an event and someone gets injured at the event, you can be sued for your personal assets to pay the damages caused at the event. Lawsuits can arise due to business activities causing harm, or for financial losses suffered.
If your business is involved in “risky activities” (i.e. bounce castle rentals), where kids could fall and get hurt, you want to make sure that you are separately incorporated and that your corporation holds insurance to cover any damages.
As a rule of thumb, the riskier the business’ activities, the more you want to consider incorporating to decrease your personal liability.
A corporation is expected to be a going concern, meaning it lives on perpetually with endless life. Of course, this is not always the case as businesses cease to exist all the time. Since a corporation is not an extension of its owners from a legal standpoint, if the owners of a corporation were to pass away, the corporation would continue to exist. This is not the case with a sole proprietorship, as the business would die with the sole proprietor.
Incorporating your business can have tax advantages, but these advantages are usually only realized when you do not need to withdraw all profits from the business as a salary to yourself. This withdrawal will trigger personal income taxes for you. When your business starts to make more money than what you need to life off of, leaving excess earnings in your business as “retained earnings” can defer personal taxes and improve the financial ratios derived from your Balance Sheet.
If you have any questions about this material, or have other questions about structuring or managing your business’ finances, I welcome you to join my community and join my monthly calls!