Lesson 2: Structures of a Business
In this lesson, we will cover the three main business structures:
sole proprietorship, partnership and corporation. We will also talk about the
liability level for each structure, as well as what each structure means in
terms of profit distribution and taxation.
Creating a business plan can help you to get a better feel for accounting.
Before you start conducting transactions, you will need to choose which
structure to use for your business. This is one of the most important decisions
you will make as it will influence many factors such as taxation, liability and
the company's ability to raise capital.
Let's explore the three different ways you can structure your business
including sole proprietorship, partnership and corporation. From an
administrative perspective, each business has different registration
requirements. The business types range in number of owners along with
complexity and benefits.
In a sole proprietorship, there is a single individual who owns the business and
is responsible for all operations. You have all the potential in
the world but you also carry all of the weight. A sole proprietor reaps all of
the benefit while carrying the full burden of liability.
Using this structure for your business will mean that
you are the sole owner. You will receive all profits from the business but will
also be subject to liability in the case of lawsuits or legal matters. If you
are sued or decide to declare bankruptcy, both your personal and business
assets will be subject to seizure.
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You may be wondering:
If I have access to all of the profits, how much will I have to
pay in taxes? Your tax rate is based on what personal tax bracket you fall
into. If you have a high income, you will ultimately pay more in taxes, while
in contrast your tax rate may be more favorable if you only have a small amount
of income from your business.
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The structure for a sole proprietorship is simple to setup and
you have full control of the business. You are
limited to the investment of a sole owner as opposed to a partnership.
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You will see that
sole proprietorships have many similarities to
partnerships but they are much different in the sense of ownership.
If you decide to go into business with another person or multiple people, you
can form a partnership. There is no limit to the number of partners, however
limiting the total number of partners can help the business run smoothly.
Whether it is 2 partners or 10, every individual plays an integral role in the
success of the business, similar to how pieces fit into a puzzle.
Just as with a sole proprietorship except with more than one owner, all
partners are fully liable for the business. Although there is a brighter side
to partnerships. With this type of business structure, you will have the option
to form a limited liability partnership (LLP). The LLP limits the liability for
some of the partners, allowing you to decide who is personally liable. Some
states require designation of a general partner, which means that person is
solely responsible for any legal matters.
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The profits are paid out to the owners of the business depending on their share
ownership percentage in the business. For example, if you own 40 percent of the
business, you would receive 40 percent of the profits. With a partnership, you
are still taxed based on your personal tax bracket which could turn out to be
either favorable or unfavorable.
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While a partnership has more administrative requirements than a sole
proprietorship, you will have access to more capital with multiple owners. This
means the business can grow much quicker and with more owners; you have access
to more creativity and innovation.
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Partnerships involve personal liability but corporations are
seen as a separate entity.
Forming a corporation is the most complex type of business structure because it
can have many investors that own a share in the company. Depending on the
number of shares, a corporation can be owned by anywhere from a just a few to
thousands of investors. Each person will have a different percentage share in
the company based on the value of stock they purchase.
Some companies like Verizon, Twitter and Exxon have millions of shares!
The share base is split up between the investors,
the amount of money you invest determines your ownership in the business.
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If you invest $10,000 in
Microsoft, you are only liable for the value of that investment. You have no
responsibility for legal matters or debts but if the corporation files
bankruptcy, you will lose your investment. This simply means that your personal
assets are safe, outside of the amount of money you invest.
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The amount of money you make is again based on the amount of shares you own and
the performance of the business. Your profits from
a corporation are delivered in
the form of share appreciation, meaning the value of the shares increases or by
paying out dividends.
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The corporation is taxed differently from
the sole proprietorship or partnership, as it falls into the corporate tax
bracket that is lower than the personal tax bracket. Normally, this rate is
between 18 and 20%. You can choose the state or country where you want to
incorporate in favor.
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You may have limited liability in
a corporation but this structure has the most fees and administrative
requirements. Starting a corporation comes with the highest potential and lower
tax rates but much more complexity.
Take a look at the table above to
compare the characteristics of each business structure: