Small business owners often consider legal structure or business entity formation when developing a business strategy. There are three main legal entities to consider:
1. Sole Proprietorship
It is the simplest form of business entity where the owner is personally liable for the business’s legal obligations and debts. It is a business entity that is managed by a single person; the owner is also the manager of the business. The owner has full control of the company and receives all the earnings, however, he or she is personally liable for all the liabilities of the company. The sole trader does not need to undergo any formal procedure to register its business, and thus it is the easiest business to establish. However, it is somehow challenging to look for funds to raise capital and has a rather short life span, which is dependent on the life of the sole trader.
2. Partnership
Under a general partnership, partners share management, control and liability of the business between them. Partnerships enable owners to leverage on one another’s ability, expertise, and knowledge. They are distributed to partners, and therefore, they are taxed at the personal level. General partnerships also have unlimited personal liability – all the partners, even those with limited involvement in the business, can be held legally accountable for partnership obligations. It is not very difficult to form partnerships, you only need to have some documents like a partnership deed.
3. Limited Liability Company (LLC)
For taxation purposes, LLCs share features of partnerships and corporations with limited liability. Similar to a partnership business, income is passed through to the owner, hence no double taxation. Similar to shareholders of a corporation, LLC members have limited liability which implies that they cannot be held responsible for the debts of the business. An LLC also involves more elaborate paperwork and registration processes as compared to that of a general partnership or proprietorship business. Though costly in terms of initial installation and subsequent maintenance, the protection from liabilities is a significant incentive for most small business people.
Choosing which legal structure is most suitable depends with each case based on several factors such as the ownership structure and the liabilities that come with the type of business, taxation as well as other laws that may affect a business at the current time or in future as the business expands. Many companies begin their operations as sole traders or partnerships and decide to convert it into an LLC as the need to protect personal assets increases. Of course, accounting and legal advisors can provide more information about the benefits and drawbacks of each option.