Everyday individuals and groups of individuals create ideas and plans to start a new business. The most important step of the planning or starting a new business is determining the legal form or structure of the new business. Business owners typically choose one of the following types of business forms: sole proprietorships, partnerships, corporations, franchises, and limited liability companies (LLC).
Sole proprietorships are business forms owned by one individual. This business structure is the simplest because it only requires the business owner to obtain licenses and permits mandated by their respective jurisdictions, owners are entitled to 100 percent of the profits, it is inexpensive, the owner has complete control, and tax preparation is easy (SBA, n.d.). A sole proprietorship is the common form selected for individuals working as freelancers or owners of small mom-and-pop establishments. While sole proprietorships have several advantages, it has multiple disadvantages. The primary disadvantages are business owners are responsible for 100 percent of the debts, losses, and liabilities and their personal assets are not protected, which means sole proprietors risk losing personal assets to creditors if they become delinquent (SBA, n.d.). Another disadvantage of being a sole proprietor is limited access to capital because business owners usually have to obtain loans or use personal assets to fund operations when the business does not generate sufficient revenues to support operating costs.
Partnerships are business structures where two or more people have interest in a business. Partnership interests may be allocated evenly among the partners or based on other allocations outlined in the partnership agreement. Allocations are generally based on each partners’ contribution to the partnership, which may include money, property, labor, or skill (SBA, n.d.). Partnerships are not as simple to form as sole proprietorships, but the process is not difficult. In most states, the business should be registered, a business name needs to be established, the owner(s) must obtain applicable licenses and permits, and an agreement must be formed to outline business operations and the allocation of profits and losses (SBA, n.d.). Partnerships may be arranged as a general partnership, limited liability partnership (LLP), or joint venture. General partnerships allocate profits, losses, and management responsibilities equally among all partners; limited liability partnerships give partners limited liability and limited management input based on their investment percentages; and joint ventures are short-term partnerships formed for special projects and dissolved at project completion (SBA, n.d.). Advantages of a partnership include the ease of formation, shared financial commitment, the ability to use the strengths of each partner to the business’ advantage, and increased employee incentives; disadvantages include joint and individual liability for debts and decisions, increased likelihood of disagreements among partners, and the requirement to share profits (SBA, n.d.).
Corporations are legal, independent entities owned by multiple shareholders and because it is considered an independent entity it is responsible for the business debts and actions, not the shareholders (SBA, n.d.). Corporations are more complicated to form than sole proprietorships and partnerships because of the various legal requirements associated with its formation. Corporations are required to establish a business name, register it with the state, select a corporate designation, obtain mandatory licenses and permits, and make arrangements with tax professionals to ensure the complex tax handling aspect will be addressed (SBA, n.d.). When establishing a corporation, owners designate it as either an S-Corp or C-Corp. C-Corps are less desirable because owners are taxed at both the corporate and personal level. S-Corps are more desirable because the owners can avoid double taxation, owners can use business expense tax credits, and the business is independent and separate from the shareholders so shareholders can come and go and the business will continue to operate (SBA, n.d.). As with other business structures, there are advantages and disadvantages associated with selecting the corporation structure. Advantages include limited liability for owners because the entity is separate from the owners and the ability to generate more capital through the sale of stock; disadvantages include additional paperwork because of associated regulations, double taxation for C-Corps, and incorporation is timely and costly (SBA, n.d.).
Limited Liabilities Companies (LLC)
Prospective business owners can select the LLC option for partnerships, corporations, or sole proprietorships. If a business opts to form as an LLC, it must meet the filing requirements applicable to its business structure in addition to filing articles or organization, creating an operating agreement, and announcing the business to the public where applicable (SBA, n.d.). Advantages of LLCs are limited liabilities for owners, less recordkeeping requirements, and fewer restrictions for profit sharing; disadvantages are they dissolve when a member leaves and members must pay self-employment taxes (SBA, n.d.).
Franchises are set up differently from the other business structures. They are agreements between a business structure and another legally independent party that gives a franchisee the right to market a product or service using the trade name or trademark of a franchisor, and use the franchisors’ operating methods while being obligated to pay franchise fees and obligating the franchisor to provide support to the franchisee (IFA, 2013). Franchises are either product distribution or business format structures and they form as either a single unit or multi-unit franchise. Advantages of franchises are the business is already recognized in the industry so owners obtain them with established customer bases and franchisors provide support in areas of financing, advertising, and training; disadvantages are franchisees must pay fees to the franchisor for the life of the business and owners have limited control over most aspects of the business (IFA, 2013).
- International Franchise Association (IFA) (2013). What is a Franchise. [online] Retrieved from: http://franchise.org/
- Small Business Association (SBA, n.d.). Choose Your Business Structure. [online] Retrieved from: http://www.sba.gov/