Lesson Objectives:- The 3 main business structures: sole proprietorship, partnership and corporation
- The liability level for each structure
- Profit distribution and taxation
- Differences and benefits of the business structures
Creating a business plan can help you to get a better feel for accounting. Before you start conducting transactions, you will need to choose which structure to use for your business. This is one of the most important decisions you will make as it will influence many factors such as taxation, liability and the company's ability to raise capital.
Let's explore the three different ways you can structure your business including sole proprietorship, partnership and corporation. From an administrative perspective, each business has different registration requirements. The business types range in number of owners along with complexity and benefits.
In a sole proprietorship, there is a single individual who owns the business and is responsible for all operations. You have all the potential in the world but you also carry all of the weight. A sole proprietor reaps all of the benefit while carrying the full burden of liability.
Using this structure for your business will mean that you are the sole owner. You will receive all profits from the business but will also be subject to liability in the case of lawsuits or legal matters. If you are sued or decide to declare bankruptcy, both your personal and business assets will be subject to seizure.
You may be wondering: If I have access to all of the profits, how much will I have to pay in taxes? Your tax rate is based on what personal tax bracket you fall into. If you have a high income, you will ultimately pay more in taxes, while in contrast your tax rate may be more favorable if you only have a small amount of income from your business.
The structure for a sole proprietorship is simple to setup and you have full control of the business. You are limited to the investment of a sole owner as opposed to a partnership.
You will see that sole proprietorships have many similarities to partnerships but they are much different in the sense of ownership.
If you decide to go into business with another person or multiple people, you can form a partnership. There is no limit to the number of partners, however limiting the total number of partners can help the business run smoothly. Whether it is 2 partners or 10, every individual plays an integral role in the success of the business, similar to how pieces fit into a puzzle.
Just as with a sole proprietorship except with more than one owner, all partners are fully liable for the business. Although there is a brighter side to partnerships. With this type of business structure, you will have the option to form a limited liability partnership (LLP). The LLP limits the liability for some of the partners, allowing you to decide who is personally liable. Some states require designation of a general partner, which means that person is solely responsible for any legal matters.
The profits are paid out to the owners of the business depending on their share ownership percentage in the business. For example, if you own 40 percent of the business, you would receive 40 percent of the profits. With a partnership, you are still taxed based on your personal tax bracket which could turn out to be either favorable or unfavorable.
While a partnership has more administrative requirements than a sole proprietorship, you will have access to more capital with multiple owners. This means the business can grow much quicker and with more owners; you have access to more creativity and innovation.
Partnerships involve personal liability but corporations are seen as a separate entity.
Forming a corporation is the most complex type of business structure because it can have many investors that own a share in the company. Depending on the number of shares, a corporation can be owned by anywhere from a just a few to thousands of investors. Each person will have a different percentage share in the company based on the value of stock they purchase.
Some companies like Verizon, Twitter and Exxon have millions of shares! The share base is split up between the investors, the amount of money you invest determines your ownership in the business.
If you invest $10,000 in Microsoft, you are only liable for the value of that investment. You have no responsibility for legal matters or debts but if the corporation files bankruptcy, you will lose your investment. This simply means that your personal assets are safe, outside of the amount of money you invest.
The amount of money you make is again based on the amount of shares you own and the performance of the business. Your profits from a corporation are delivered in the form of share appreciation, meaning the value of the shares increases or by paying out dividends.
The corporation is taxed differently from the sole proprietorship or partnership, as it falls into the corporate tax bracket that is lower than the personal tax bracket. Normally, this rate is between 18 and 20%. You can choose the state or country where you want to incorporate in favor.
You may have limited liability in a corporation but this structure has the most fees and administrative requirements. Starting a corporation comes with the highest potential and lower tax rates but much more complexity.
Take a look at the table above to compare the characteristics of each business structure: