When starting a new company, deciding what kind of organisational structure to utilise is one of the most crucial decisions to make. This decision may have an impact on different aspects like taxes and personal liability. Since there are a few structures, gaining a better understanding of each of them will assist you in determining which type of business structure is ideal for your organisation. This article will describe the most common business structures that should be considered when starting a business, as well as some of the benefits associated with each structure and the factors that should be taken into account when selecting one.
What is a Business Structure?
If you have ever worked for a company, rented an apartment, or purchased a vehicle, you may have signed a contract in which you were required to represent yourself. On the other side of the contract, however, the signature lines can show that someone is signing on behalf of a company. For that company to enter into a contract, it is required to use a legitimate corporate structure and to keep its registration with the state government in good standing at all times.
When you sign a contract or do business as yourself, which is the default if you start a business but don’t register it, you are personally accountable for everything that goes wrong. If you make a mistake while working with a customer or if your product or service causes harm to another individual, you may be personally accountable for any financial damages that result. That indicates they have the legal right to sue you and potentially seize your assets, such as your bank accounts, investments, and home. Your private property and finances are safeguarded when you run a company that is legally recognized and adheres to industry standards.
Your company is assumed to be a sole proprietorship by default, which means that you are the business, and all transactions are done under your name. When you form a limited liability company (LLC), corporation, or partnership, the new entity will take your place on contracts. When you achieve a specific income threshold and are actively engaged in the operation of the business on a full-time basis, you become eligible for additional tax benefits.However, legal restrictions apply to corporate companies. Getting a firm off the ground and running can cost a different amount of money in each state. You may be able to file the registration papers on your own, but many individuals opt to engage a lawyer to guarantee that the business is founded lawfully and remains by local, state, and federal regulations. Because each company and its owner is unique, it may be beneficial to seek the counsel of a tax or legal expert to select the organisational form that will allow you to achieve your long-term objectives most effectively. You can check more on Business Tax Breakdown: Understanding Tax Implications. Let’s get into the top business structures in the world of business.
Top types of business structures
1. Sole Proprietorship
This is a one-person operation that is only focused on the owner’s financial gain. It is the most basic type of organisational structure for a company. There is no such thing as a proprietorship that exists independently of its owners. The proprietor’s assets are responsible for paying any debts that are incurred by the company, and the proprietor’s passing puts an end to the company’s operations. The owner of the business is responsible for bearing all of the associated risks to the extent of the assets under their control, regardless of whether or not those assets are utilised in the operation of the firm.
Single proprietors are professionals, service providers, and retailers who are “in business for themselves.” For accounting, a sole proprietorship should be treated as a separate entity even though it does not exist as a distinct legal entity from its owner. The person’s financial operations (such as making payments on a house) are kept in a separate account from the business’s financial activities (like receiving fees, for example).
Pros of Sole Proprietorship
- Easy to start
In most cases, the sole proprietorship is the type of business structure that is considered to be the default. This means that anyone who begins operating their business without taking any additional procedures will automatically become a sole proprietor.
In most cases, the sole proprietorship is the type of business structure that is considered to be the default. This means that anyone who begins operating their business without taking any additional procedures will automatically become a sole proprietor.
- Cost-effective
The cost of establishing a sole proprietorship is typically quite modest, requiring either no initial capital at all or only a nominal registration fee.
- Continuity of compliance
The standards for ongoing compliance are typically rather light. There is no necessity for a business to register annual filings, nor is there a requirement for financial accounts to be audited. However, tax returns are required to be filed at the proper intervals, which are generally quarterly.
- Simplified taxation
In most cases, the owner of a business is allowed to subtract a certain number of expenses from their revenue before being subjected to the same level of ‘personal income’ taxation as an employee would be.
- Cons of a sole proprietorship
This type of business structure has several advantages, but it also has some drawbacks, the most significant of which are as follows:
- Higher taxation
Even though paying taxes may be simpler for sole proprietors, successful businesses typically pay a greater percentage of their revenue in income tax than they would if they were incorporated. This is because the business is treated as an individual taxpayer.
The reason for this is that personal income tax rates tend to be significantly higher than corporate income tax rates in the majority of countries. In addition, a corporation can hand out dividends to its shareholders, which are subject to a rate of taxation that is lower than that applicable to company income.
- Difficult to raise funds or take on debt
When a firm is operated under the model of a sole proprietorship, no equity in the company can be purchased by a third party in the form of shares. In addition, lenders are more hesitant to make loans to sole owners since the proprietor’s financial troubles have a greater potential to easily disrupt the operations of the business if they arise.
- Uncapped legal responsibility
In a sole proprietorship, the owner of the firm is personally liable for any debts incurred by the company. If the company goes bankrupt, creditors have the legal right to put the owner of the company into personal bankruptcy and seize whatever personal assets they have, including the family home and personal bank accounts.
Partnership
A partnership is a business arrangement where two or more persons share ownership and management responsibilities. The owners of a partnership can put their business idea to the test before committing to a more formal structure. This makes it one of the easiest options for organisations with several owners or groups of professionals. Both “general” and “limited” partnerships exist. Each member of a general partnership shares equally in the company’s ownership and management responsibilities and liabilities.
As in any general partnership, the general partners are responsible for and held liable for the actions of the partnership as a whole. Limited partners, who are typically investors, have little to no management responsibility and no legal responsibility for the company’s actions. The profits of the business are shown on the partners’ tax returns as well.
Pros of Partnership
- Control
The partners are actively involved in running the company daily. There are no silent’ partners who don’t contribute to day-to-day operations but have a significant say over major decisions.
- Easy to start
To form a partnership, business associates must first agree to work together under the provisions of a formal partnership agreement. The partnership can begin operating immediately without filing any paperwork with any government agency.
- Privacy
The identities of the partners, the amount each has invested, and the partnership’s financial status are all confidential business. Unlike shareholdings and directorships of corporations, this information is not disclosed publicly.
- Flexibility
Since a partnership is the result of the voluntary agreement of two or more people, it can be organised in whatever way the partners see fit, usually without resorting to the statute.
Cons of Partnership
- Infinite responsibility
In a general partnership, all partners are jointly and severally liable for the partnership’s debts. Therefore, the partners’ wealth is in danger if the business fails. In some countries, only the ‘limited partners’ of a limited partnership are subject to legal responsibility for the actions of the partnership. The day-to-day business managers, or general partners, must have unlimited liability even in a limited liability partnership.
- Challenges in obtaining financing or securing debt
It is more challenging to obtain loans for a partnership than for a single proprietorship, but numerous partners can contribute. When a third party buys into a limited partnership, things go more smoothly for everyone involved.
- Difficulty making a choice
All significant decisions in a partnership must have unanimous approval from all partners. This slows down their ability to react to situations. It also raises the possibility that disagreements in character will cloud professional judgement.
Corporation
Corporations are distinct legal entities that are brought into existence by their stockholders. When a company is incorporated, its owners are shielded from personal liability if the firm incurs debt or gets into a legal conflict. When compared to the other three varieties of organisations, starting a corporation is the most challenging option to pursue.
If one of the owners of a sole proprietorship or partnership passes away or declares bankruptcy, the company will be dissolved. Corporations are recognised in the law as distinct entities from their shareholders. As a result, they are safe from the consequences of this scenario and will proceed with their operations even after the death of a shareholder. You can check out Australia’s changes to company tax in 2024 for more insights.
There are three primary categories of corporations, which are as follow
a. The C Corporation
This is by far the most common type of company incorporation. The corporation is subject to taxation as an independent legal body, and the owners of the corporation get profits that are subject to individual taxation as well.
b. The S Corporation
This is quite similar to a C corporation, however, the number of stockholders is limited to no more than 100. S corporations are considered pass-through businesses, much like partnerships, which means that profits do not face double taxation.
c. Non-profit Corporation
Tax exemptions are available to non-profit corporations, which are frequently utilised by philanthropic groups. The business is required to put any sources of financial flow it receives into either its current operations or its long-term planning.
Pros of corporation
- Because the owners of an S Corp or C Corp are also shareholders, they are afforded a higher level of legal protection, provided that the business is run properly.
- The company can engage in contracts and carry out other business as its separate legal entity because it behaves like a person under the law.
- S corporations, on the other hand, are limited to a maximum of 100 stockholders but can have an unlimited number. The number of stockholders in a C corporation is not limited.
Cons of corporation
- Establishing and running a corporation often requires additional labour as well as extra fees. This makes the overall cost of establishing and running a corporation significantly greater.
- To maintain their legal existence, corporations are required to hold yearly meetings, select a board of directors, and adhere to a variety of other state-mandated laws.
4. LLC
One of the most adaptable business structures is a limited liability company (LLC). LLCs are hybrid entities that share characteristics of both partnerships and corporations. They profit financially from both the simplicity of a sole proprietorship and the security of a corporation. Limited liability companies (LLCs) can opt for a variety of tax structures. The LLC will keep its flow-through taxation status if it opts out of C-corporation treatment.
Pros of Limited Liability Company
- Liability restrictions
The word “limited” right there in the name indicates that the member’s assets are shielded from the possibility of corporate insolvency. It’s important to keep in mind, though, that creditors can “pierce the corporate veil” and go after members personally under specific conditions. In addition, whenever a member has personally guaranteed a loan (which is quite common), that member’s assets will be used to pay off the debt.
- Abatements of taxes
The simple tax pass-through means that forming an LLC has few additional tax consequences.
- Flexibility
Few stipulations are made as to the actual operation of the business: The members can, for instance, hire outside managers instead of trying to handle every aspect of running the company themselves. An “operating agreement” should detail the intended procedures for running the business.
Cons of LLCs
- Pressure to conform
The LLC is subject to the same annual compliance standards as any other corporation because of its status as a legal entity.
- Single-owner LLC are susceptible
General asset protection requirements may not apply to a single-member LLC. The possibility that a judge would “pierce the corporate veil” and hold individual members personally accountable for business obligations increases when business and personal monies have been mixed.
- Costs more in taxes
The same self-employment and payroll taxes that a solo entrepreneur would owe could apply to members who work in the business.
How to Choose the Ideal Business Structure for Your Business
Here are six points to consider when picking a business structure for your new company:
- Control: A sole proprietorship or LLC gives you main control. Corporations need a board of directors, but partnerships can specify their control.
- Capital investment: Single proprietorships use their credit or take on partners, while corporations sell stock or get bank loans. If an LLC has trouble raising finances, the owner doesn’t have to use their assets or credit.
- Flexibility: Compare each structure to your goals and company plan. The structure should enable development and change.
- Complexity: Sole proprietorships are the simplest business structures, although they may be harder to fund. Corporations, LLCs, and partnerships must report to state and federal governments.
- Liability: A corporation has the least liability because creditors or customers can sue the firm but not its assets. The other formations include LLCs, partnerships, and single proprietorships.
- Taxes: Sole proprietors and LLC owners pay personal income taxes, whereas partnerships claim their share of profits as personal income. Corporations pay taxes on profits and file their tax filings.
Conclusion
Understanding the different types of business entities and their tax implications is crucial for any entrepreneur or business owner. Each type of entity has its own unique set of advantages and disadvantages when it comes to taxes, liability, management, and ownership. Ultimately, the choice of business entity will depend on a variety of factors, including the business’s goals, size, structure, and financial situation. It is important to consult with a qualified tax professional when making this decision. This ensures that the chosen entity meets the business’s needs and complies with all applicable laws and regulations.
Fortunately, The Kalculators can help you select the best business structure for your company. When it comes to establishing a business or making hires in a foreign country, The Kalculators is your go-to resource for worldwide expertise. Have a conversation with one of our experts on international growth to determine what’s best for you and your business.
Frequently Asked Questions
What are the different types of business structures, and how do their tax breaks differ?
You must pay different taxes if you run your business as a sole proprietorship, a partnership, an LLC, or a company. Businesses that one person runs are taxed at their rates. On the other hand, partnerships are taxed pass-through, meaning each partner’s gains and losses are reported on their tax returns. Regarding taxes, LLC owners can be taxed as a single proprietorship, a partnership, a S Corporation, or a C Corporation. Corporations, especially C Corporations, are taxed twice: on profits and dividends, the company and its shareholders are taxed.
What is the best way to figure out which business structure will save me the most money on taxes?
There are many things to think about when picking the right business format, such as how to protect yourself from liability, how to run the business, how you want it to grow in the future, and how it will affect your taxes. Talking to a lawyer or financial expert can help you weigh the pros and cons of each structure and make a choice that fits your business and tax goals.
How does a business change its organisation over time, and what does that mean?
Yes, businesses can change how they are set up as they grow and change. However, reorganising a business might have legal and tax effects that must be carefully considered. The process might involve submitting paperwork to the right people and could have tax implications, so getting professional help is important to make the change go easily.
How can The Kalculators help Australians understand the tax effects of different business structures?
The Kalculators are experts at giving you expert help and tools that are perfect for your business. Whether you’re a new business looking at different structures or an existing business thinking about reorganising, our team can help you every step of the way. We’ll help you understand each structure’s tax pros and cons and advise you on tax planning and compliance so you can make smart choices for the financial health of your business. Let us help you confidently find your way through the complicated world of business structures and tax effects.