Understanding the pros and cons of business entities is extremely important when starting your own company. While choosing to start a new business can be full of excitement, choosing what type of legal structure you will operate under is one of the most important decisions to be made. The options available share various advantages and disadvantages and will impact how your business will operate, the amount of paperwork you will do, your tax rate, the personal liability you will face, and your ability to raise capital.

What Are the Three Basic Types of Business Structures?

  • Sole proprietorship
  • Partnership
  • Limited liability company

What Is a Sole Proprietorship?

A sole proprietorship is the default structure for business owners who take no action in the formation process. It is the simplest form of business to conduct. In a sole proprietorship, there is one person who manages and controls the operation of the business. This one person is referred to as the owner of the business. In essence, the business and owner are one and the same.

This means you are the one who makes all the decisions, and you do not have to consult with other owners or members. This also means any profits or losses are yours. A sole proprietorship does not branch out in other areas. Some common types of sole proprietorships are simple shops, restaurants, boutiques, and canteens.

Since owners take on all the risk of the business with no personal protection, sole proprietorships are often frowned upon. If the business doesn't succeed, creditors can attempt to collect the business assets as well as the owner's personal wealth. The appealing side of a sole proprietorship is that formation costs nothing. There is no tax liability when transferring possessions or money between the owner and the business because they are considered one in the same

What Is a Partnership?

When there are two or more owners, the business entity is considered a partnership instead of a sole proprietorship. Normally, the partners/owners will contribute money to raise capital to start the business. The partners share the responsibility in making decisions and determining how the business will function.

It is common for partners to allocate various roles and responsibilities to owners according to the expertise they may possess. This is to ensure the business operates efficiently and performs to its maximum potential.

Partnerships are fairly simple to form and take a short amount of time to establish. Profits are distributed according to the ratio of capital contributions made on behalf of each owner. Naturally, the more you invest, the more profit you are going to enjoy. Partnerships have the advantage of flexibility and offer owners a wider pool of knowledge, skills, and contacts. The ability to raise funds tends to be easier when there is more than one owner.

In a partnership, owners have unlimited liability as seen in sole proprietorships. Each partner is at risk of losing personal assets if the business is not successful; this means that each partner is jointly liable for the partnership's debts.

There is also a risk of disagreements and friction between partners. This is why it is critical to make sure partners share a common goal and have the same vision for the business at the beginning. Another downfall in a partnership is that a partner cannot transfer an interest in the business without all owners/members agreeing. Plus, partnerships can be unstable due to a danger of dissolution if one partner dies or wants to withdraw from the business.

What Is an LLC?

Limited liability companies, also known as LLCs, are another legal structure and offer several advantages over the previous two discussed. The major advantage is an LLC is considered to be a separate entity from the owner(s). This separates the owner's assets from the business. In the event of a lawsuit, creditors cannot collect the owner's personal assets.

There is no limit to the number of owners in an LLC, and the company is operated according to an operating agreement. In addition, when it comes to taxation, LLCs get the best of both worlds. LLC's can adopt the tax status of a sole proprietorship, partnerships, S corps, or C corps. This means the LLC can pass through taxation to the owners and avoid double taxation.

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