Key Takeaways
- The three common legal forms of business are sole proprietorship, partnership and corporation. Each legal form has their own advantages and disadvantages.
- Important factors to consider before registering your business are as follows: ownership, capital size, financing, personal liability, taxation, regulatory requirements, control, and continuity.
Disclaimer: The information contained in this section is for educational purposes only and is intended to supplement your own research. This information is not a substitute for legal or business advice and should not be relied upon as a basis for making decisions. Be sure to seek advice from a qualified attorney, accountant or consultant who is licensed in your area or jurisdiction.
Introduction to the Legal Forms of Business
If you’re a business owner or manager, there are a lot of things that you’ll need to iron out so that your business can function effectively. One of them is determining the appropriate legal form for your business.
The three most common legal forms of business are sole proprietorship, partnership and corporation. Each form has their unique characteristics that can either be an advantage or a disadvantage to the owner/s.
A business exists and operates in a complex environment. It is largely affected by several factors that are related to regulations, politics, economy, taxes, market forces, and even culture. This is the reason why starting and running your own business is hard and risky.
One challenge that businesses continually face is the adherence to regulatory requirements. It’s important for a business to adhere to regulations and laws in order to avoid any legal roadblocks along the way.
Choosing the right legal form for your business
When setting up your business, you have to make it formal by registering with the proper government regulatory agency that is in charge of business registrations in your area. You need to determine which legal form of business is appropriate to the needs and functions of your business.
Below are several factors to consider and questions to answer when deciding about the legal form in which you’ll organize your business:
- Ownership – How many owners or investors does your business have/need? At what amount will each owner share in the profits and net assets of the business? What will be the limitations to their ownership? How can the investors or owners transfer ownership to others?
- Capital – What will be the size or amount of capital that is required for your business to meet its operational and financial needs?
- Personal Liability – Are you willing to assume personal liability for the debts of your business?
- Taxation – What are the tax advantages? What are the tax requirements for both the corporate level and individual level?
- Tolerance – What is your tolerance level when it comes to documentation, regulatory and tax requirements. How much risk can you tolerate?
- Control – How much control do you want to retain over the management and decision-making process of the business?
- Stability or continuity – Can the business continue when one of the owners die or withdraw from the business?
There is no right or wrong legal form of business. Your initial choice is also not permanent and could change over time as your business grows and as additional funding and protection is required.
Each form of business has its own advantages and disadvantages. There is no one size fits all and you just need to weigh the pros and cons of each. That’s why it’s very important that you consult with a professional such as a lawyer or an accountant first before making a decision.
Sole Proprietorship
A Sole Proprietorship is a form of business that is owned by a single person whose intention is to have complete control over the decisions and profits of the business. The owner of a sole proprietorship is called a Proprietor or Sole Proprietor.
A sole proprietorship is the most common legal form for small businesses with few employees and self-employed persons such as freelancers and practitioners who are not subject to an employer-employee relationship with any company. This is the preferred choice of business owners who don’t intend to share ownership and management with a partner, investor or cofounder.
Sole proprietorship is preferable under the following conditions:
- When you are less likely to be sued. If in case you get sued, the risk should only be minimal and can be adequately covered by insurance.
- When you anticipate that your business does not necessarily need to borrow large sums of money.
- When you prefer less complicated regulatory and tax requirements.
Advantages of a sole proprietorship
- Simple to establish – compared to partnerships and corporations, a sole proprietorship is easier to set-up due to fewer legal requirements and regulations. Corporate documents such as articles of incorporation and by-laws are not required to be submitted to the government.
- Easy to dissolve – if you decide to close the business down, it will be easier and inexpensive because you’re the only one who owns it and the exit requirements are fewer.
- Full ownership and control – as a sole proprietor, you have more freedom and control over the decision-making and management of your business. You also reap all the profits and rewards for yourself.
- Pass-through income – the net income your business earns passes or flows directly to you. This means all profits from the business are accounted for as your personal property and are taxed based on individual tax rates. This could create a tax advantage because double taxation is avoided since the business itself doesn’t pay any income tax.
What is double taxation? It refers to a situation where taxes are paid twice on the same source of income.
Disadvantages of a sole proprietorship
- Capital limitations – your potential to raise funds can be limited as a sole proprietor compared to more complex forms of businesses such as corporations.
- Loses – while you may enjoy full ownership of the profits made by the business, you also risk absorbing all losses that may result from its operations.
- Unlimited liability – from a legal standpoint, you are not viewed as separate and distinct from your business. This makes you personally liable for all business debts and court judgments against the business. When the business defaults on any of its obligations, your personal properties could be forfeited in favor of the creditors.
- Lack of continuity – compared to corporations where the business could still continue its normal operations even if there are changes in ownership, a sole proprietorship business will cease to exist upon the death or retirement of the owner.
- Limited skills and knowledge – unless you hire employees to help you, the management of your business will only be limited to your own skills and knowledge.
Partnership
A Partnership is a legal form of business where two or more individuals agree to combine their resources and services for a common objective and share any profits or losses among themselves. The owners of a partnership are called Partners.
While being a sole proprietor gives you full ownership and control over the business, forming a partnership with other individuals has its own benefits.
First, when each partner contributes capital, the combined amounts could give the business a head start compared to the capital limitations in a sole proprietorship. Each partner also acquires ownership rights that are usually proportionate to their capital contributions, unless stated otherwise in the partnership agreement.
Second, the expression “two heads are better than one” best describes the shared expertise that is inherent in most partnerships. More people working together could produce better results, especially if each person has expertise that complements the others.
For example, if you’re an accountant who specializes in tax planning and preparation, you can establish an accounting firm with individuals who have expertise in other fields such as accounting, payroll, auditing, assurance, and management advisory. This kind of partnership where partners agree to practice and offer their professional services is referred to as a Professional Partnership.
General partner vs. Limited partner
There are two main types of partners based on their capital contribution and the liability they are willing to assume, namely: General Partner and Limited Partner.
A General Partner takes over the management role of the business and may enter into contracts on behalf of the partnership. However, if you choose to become a general partner, you assume the risk that your personal assets could be forfeited in favor of creditors for the payment of business debts. Having unlimited liability is a responsibility that the general partner assumes as a result of making critical management decisions on behalf of the partnership.
On the other hand, if you opted to become a Limited Partner, your share in business debts is only limited to your capital contribution. This means that you cannot be held liable personally for the debts of the business. However, limited partners only act as investors and are not allowed to manage the business.
Your choice to become either a general partner or a limited partner is largely dependent on your risk tolerance. If you can risk having your personal assets attached in favor of creditors for the payment of business debts, then you may choose to become a general partner. Otherwise, becoming a limited partner is a safer option.
Advantages of a partnership
- Ease of formation – you’ll find it easier to establish a partnership because it has fewer legal requirements, tax filings and start-up costs compared to a corporation.
- Multiple sources of capital – if compared to a sole proprietorship, a partnership can raise more capital from the combined contribution of resources by the partners.
- More management expertise – aside from capital contributions, your partners can also contribute their skills and expertise to effectively manage the business. In this case, managerial responsibilities are divided among the partners. This makes a partnership more flexible to manage than a corporation in terms of decision making because only the partners have a say in the management of the business.
- No double taxation – similar to the pass-through income that we discussed earlier as one of the advantages of a sole proprietorship, the earnings of a partnership flow directly to the partners and are reported on their individual personal income tax returns. Double-taxation of the same income is avoided because the partnership does not pay taxes on its income.
- Risks are spread – unlike a sole proprietor who bears all the risk of loss that the business may suffer, the income or loss in the partnership is distributed among the partners in accordance with the partnership agreement. In addition, when a partner becomes unavailable to work due to a sickness or other reasons, any partner with management responsibilities could take over any task or project that the former may have left.
Disadvantages of a partnership
- Unlimited liability – as we have discussed above about the differences between a general partner and a limited partner, a general partner’s personal assets may be forfeited in favor of a creditor for the payment of any debt that may be owed to the latter. Unlimited liability does not apply to limited partners.
- Taxable personal share on business income – while only the distribution of profits among partners are taxed as personal income and not the business itself, this may become a disadvantage when individual tax rates are high in your local area or jurisdiction.
- Disagreements – due to the shared management of the business, any quarrel or disagreements among the partners may affect relationships as well as business operations. Furthermore, other partners could suffer or be held liable for any bad decisions that another partner makes.
- Capital limitations – a partnership has more limitations in raising capital compared to a corporation where large amounts of capital can be obtained by selling equity shares to the public.
- Lack of continuity – a partnership could be dissolved or terminated easily upon the death of a partner or the withdrawal of ownership by a partner from the business.
- Transfer of ownership limitations – a partner cannot just sell or transfer his ownership interest without the consent of all the partners.
- Profit sharing – a partnership agreement could state that profits will be shared equally among the partners or in an amount that is different and not in direct proportion to their capital contributions. However, there may be inequalities when one or more partners who are not putting the same amount of effort as others in the management of the business still receive the same rewards.
Corporation
A Corporation is an artificial being created by operation of law and has a legal personality that is separate and distinct from its owners. The owners or investors of a corporation are called Shareholders or Stockholders.
For you to understand this definition, let’s break it down into the following:
- A corporation is an artificial being created by operation of law – this means that a corporation is like a person but artificially created by law through the process of incorporation. As an artificial being, it has been granted by law certain legal rights and duties just like what a natural person has. A corporation can own assets, incur liabilities, sue or get sued, and enter into legal contracts with other entities or individuals.
- A corporation has a legal personality that is separate and distinct from its owners – as an artificial being that’s given its own rights, privileges and duties, a corporation is seen as separate and distinct from its shareholders. For example, shareholders cannot enter into contracts directly on behalf of the corporation, nor can they be sued when the latter is involved in a lawsuit.
When you start a business, you may initially establish it as a sole proprietorship or a partnership especially if you’re just trying out a business idea. As you begin to grow and scale your business, you may consider shifting to a corporate form of business as it could give you more opportunities for additional funding and protection. However, there’s no stopping you from registering your startup business directly as a corporation if you already have the experience, funds and capability to navigate the complicacies of a corporation.
Advantages of a corporation
- Centralized management – unlike a sole proprietorship or partnership, ownership and management in a corporation are separate from each other. A corporation is managed by the Board of Directors, a group of people elected by shareholders to represent them, oversee corporate operations and make high level decisions for the business.
- Limited liability – similar to limited partners, shareholders only act as investors and are not allowed to manage the corporation. They are only liable to the extent of their investments, and their personal assets cannot be attached to pay corporate debts.
- Easy transferability of ownership – it’s easier for shareholders to sell or transfer ownership of shares without affecting the operations or legal structure of the corporation. This is more applicable to publicly-held corporations whose shares are traded in a stock exchange. Buying and selling shares are easier nowadays as it can be done with just a few taps in an investment or trading app that is installed on a mobile phone. However, transfer of ownership could be more difficult for privately-owned corporations whose shares are not traded in a public exchange.
- Continuity and unlimited life – corporations are assumed to have unlimited life and will continue to operate and exist as a legal entity even when shareholders, board of directors and corporate executives change.
- Source of capital – corporations have the ability to raise substantial amounts of capital from a wider shareholder base. A privately-owned corporation can have access to huge capital by going public through the process of initial public offering (IPO) wherein corporate shares are issued and sold at a public exchange for the first time. Selling shares provide corporations with a stronger financial base to support expansion and product innovation. Furthermore, there’s no limit to the number of shareholders a corporation can have.
- Tax advantages – corporations can enjoy certain tax-deductible business expenses that can be used to minimize taxes legally. Businesses and investors are more attracted to countries or jurisdictions that offer tax incentives to promote economic growth.
Disadvantages of a corporation
- Regulation and documentation – incorporating a business can be complex, time-consuming and costly due to the number of legal and tax requirements. Corporations, particularly those publicly-held, are subject to stricter regulations. As a result, they are required to maintain and submit a lot of documentations and paperworks that include audited financial statements and annual shareholder reports.
- Double taxation – corporate profits can be subject to double taxation when taxes on dividends are paid in addition to income taxes.
- Management manipulation – it is possible that the Board of Directors and officers in a corporation can act against the welfare of shareholders and the public and in favor of their personal interests. This could happen when no oversight systems are in place to protect shareholders and the public.
C corporation and S corporation
In the United States, there are two kinds of corporations that you can choose if you’re considering how you want to be taxed – namely, C Corporations and S Corporations.
C Corporations are those that represent the majority of corporations. From an income tax point of view, the income of a C Corporation can be subject to double taxation, which is a disadvantage. Corporate taxes are paid on net income. Additional taxes are paid when that income are distributed to shareholders in the form of dividends.
S Corporations, on the other hand, are pass-through corporations whose income flows directly to the shareholders, much like in a sole proprietorship and partnership. This avoids double taxation because the net income is not taxed at a corporate level. Instead, it is the shareholders who will have to report their share of the taxable income on their personal tax returns. However, S Corporations are subject to certain restrictions such as being allowed to have a maximum of 100 shareholders only. This could limit the growth and potential for acquiring more capital from other shareholders beyond the capped amount.
Limited Liability Company (LLC)
A Limited Liability Company or LLC is a common form of business organization in the United States. It is a hybrid business entity that combines the limited liability characteristic of a corporation and the pass-through income taxation of a sole proprietorship, partnership and S Corporation.
An LLC can also choose to be taxed as a C Corporation and be subject to double taxation. This is an advantage when a significant portion of the profits will be retained in the company rather than distributed to the owners.
An LLC is not a corporation and can be formed by a single person or an unlimited number of members. It has more flexibility than a corporation regarding management roles and division of profits. However, a very detailed agreement on the division of profits and management roles, as well as the rights to contribute and withdraw capital are required for such flexibility.
While LLCs are only available in the United States, you could do some research and consult with a qualified lawyer or business advisor if an equivalent form of business is available in your country or jurisdiction.
Review Questions
- What are some of the advantages and disadvantages of registering as a sole proprietorship, partnership and corporation?
- What are the differences between General Partner and Limited Partner?
- Why do you need to consider the extent of personal liability of the owner of a business?
- What legal forms of business are designed to prevent double taxation?
- What are the differences between C Corporations, S Corporations and LLCs?
