When you start a small business it needs to operate under a specific legal structure for both liability and taxation purposes. In the western world, there are three main types of legal frameworks for small businesses:
1) Sole Proprietorship
2) Limited Liability Company (LLC)
Keep in mind that no matter what option you choose, you can always change it later. In all three business framework options there are advantages and disadvantages. Only you can decide which legal structure suits your needs. You should consider soliciting advice from an accountant and/or a lawyer during your planning process if you’re not certain. Of the three options, the two most popular choices are a sole proprietorship and limited liability company.
A sole proprietorship is the simplest form of a business. It’s typically used by very small businesses, such as businesses operated out of someone’s home. The advantage of being a sole proprietor is freedom from officialdom. You’re allowed to keep simple, un-audited accounts. Like any enterprise, you must account for every penny coming in and out of the business with a simple bookkeeping system. In addition, unless the wages you take from your business are very high, your total tax payments can be lower than if you’d set up a limited liability company.
The disadvantages of being a sole proprietor are quite minimal relative to the benefits. Nevertheless, there are four major disadvantages:
- You are the company, which means that you are liable for any business debts you incur. If you go broke, your creditors can take away everything you own including your house and car.
- As a self-employed sole proprietor, you might receive less social security payments from the government than the average citizen.
- Sole proprietors can often find it difficult to obtain funding from outside sources. Banks and investors prefer to lend money to limited liability companies.
- A sole proprietorship business is harder to sell and harder to pass on to a successor.
Limited Liability Company (LLC)
Another option in setting up a business is the framework of a limited liability company, most commonly known as an LLC. The important thing to realize about a limited liability company is that the company stands alone in its own right. This arrangement differs from that of a sole proprietorship, in which you and the company are one and the same.
The limited liability company framework offers several advantages, including:
- The framework has more credibility in the marketplace. People know you have made the effort to have everything registered with the relevant authorities.
- Your liability as an employee of the company is limited to the number of shares you have invested in the company. This is true even if you’re the CEO. As such, unless you sign personal guarantees or do something illegal, creditors can’t touch your personal assets if the company goes broke.
- It’s easier to raise large sums of money from banks, business angels, or investors if you have a limited liability company. It’s also easier to sell the company down the road.
The third business framework option is a partnership. A simple partnership is similar in many ways to a sole proprietorship but is designed for multiple owners. Each partner is jointly and personally liable for their own actions and the actions of each of the other partners. A partnership can always raise money by introducing new partners to the business. However, it’s essential that partnerships are formed with partnership agreements written up by an attorney that spells out the following:
- Who the partnership shareholder is
- How the profits should be distributed
- The capital each partner contributes
- How the business is to be managed and run
- Limits to the amount a partner can draw without the other partner(s) knowing
- Arrangements for bringing in new partners
Many partnerships fail. You might end up in a situation in which one partner complains because he or she feels that the other partner is not pulling their weight. A partnership is not unlike a marriage, wherein the people in the partnership must cooperate despite their personal issues. For this and other reasons, a partnership agreement should function to provide a modicum of objective protection.
As always, consult with your lawyer and/or accountant to determine what is best for you and your business needs. The ideal legal structure for your business depends on a variety of factors, so it’s critical that you perform adequate due diligence and consider the benefits and risks accordingly.
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