Structuring Your New Business - Pros & Cons of Four Common Legal Structures

One of the first major decisions a new business owner must decide is how to structure his or her company. Four of the most common legal business forms are (1) sole proprietorship, (2) partnership, (3) limited liability company (LLC), and (4) corporation. Consequently, I have put together a list of some pros and cons of each of these structures so you may have an easier time deciding which form might be best for your company.

First, what exactly is a sole proprietorship? This type of business, also referred to as simply a proprietorship, has only a single owner (Wild, Larson & Chiapetta, 2007, p. 10). It is actually pretty common for business owners to decide to first open their company as a sole proprietorship (Small Business Advantages, n.d.).

Pros of Sole Proprietorships

(1) Proprietorships are considered the simplest and least expensive form to start and operate (BusinessTown.com, 2003; Davidson, 2000).

(2) Income is only taxed once, rather than first as company income and then as personal income (Small Business Advantages, n.d.; Wild et al, 2007, p. 10).

(3) The owner does not have to vie with partners or shareholders to determine the company's direction or how its profits should be used (BusinessTown.com, 2003; Small Business Advantages, n.d.).

(4) This form is fairly easy to dissolve if such an action becomes necessary (Small Business Advantages, n.d.).

(5) Proprietorships have less government control and taxation than some of the other forms of business organization (BusinessTown.com, 2003)

Cons of Sole Proprietorships

(1) The law does not recognize a distinction between owner and company; therefore, the owner's own personal assets can be endangered by company liabilities if the business accumulates too much debt (Small Business Advantages, n.d.; Wild et al, 2007, p. 10).

(2) Owners of proprietorships can have problems raising enough capital since they are only one person (BusinessTown.com, 2003; Small Business Advantages, n.d.).

(3) A personal difficulty or tragedy for the owner could mean the end of the proprietorship (BusinessTown.com, 2003).

(4) The owner must make all the important decisions himself/herself. Consequently, the success of the business weighs heavily on the abilities of the single owner (BusinessTown.com, 2003).

(5) Certain employee benefits cannot be directly deducted from the company's income. Instead, only part of the cost can later be deducted as an adjustment (Small Business Advantages, n.d.).

Now we can move on to the second legal business form: the partnership. This type of business is created and then operated by at least two different individuals (partners). The partners merely have to establish a written (or even oral) agreement "to run a business together" (Wild et al, 2007, p. 10).

Pros of Partnerships

(1) Like a proprietorship, the company's income is only taxed once (the profits are split between the partners and then taxed as personal income) (Nolo, 1999; Wild et al, 2007, p. 10).

(2) Also, like a proprietorship, partnerships are relatively simple and inexpensive to form and operate (Davidson, 2000; Nolo, 1999).

(3) More owners logically can provide more opportunities for capital and can lend more experience and perspectives when making important decisions (especially if the owners choose partners that have skills and/or experience that complement their own).

(4) Partners share the day-to-day operations of a business, putting less stress and obligations on each individual (Nolo, 1999).

Cons of Partnerships

(1) Obviously, if partners are not in sync with their priorities and vision for the company, it could spell financial doom for all those involved since all "the business-related acts of one partner legally bind all others" (Nolo, 1999, para. 1).

(2) Like proprietorships, all partners can individually be held responsible for all debt and other liabilities that the company accumulates (Davidson, 2000; Wild et al, 2007, p. 10).

(3) The partners must divide the profits among themselves and decided together how these profits should be used.

The third kind of business that I researched was the limited liability company (LLC). LLCs are actually a type of partnership and are a hybrid of "characteristics of the corporate structure and the partnership structure" (Davidson, 2000, Limited Liability Company [LLC] section). Ultimately, LLCs attempt to capture the best qualities of both of these forms, making it one of the most popular ways to operate a business today (Davidson, 2000; Wild et al, 2007, p. 11).

Pros of Limited Liability Companies (LLCs)

(1) The members of the LLC cannot be held liable for company debts and other liabilities, similar to a corporation (Davidson, 2000; Wild et al, 2007, p. 11).

(2) If the LLC is structured correctly, it can also still be taxed like a partnership (Davidson, 2000; Wild et al, 2007, p. 11).

(3) LLCs can be owned by nearly any entity, including "individuals (residents or foreigners), corporations, other LLCs, trusts, pension plans etc." (Davidson, 2000, Limited Liability Company [LLC] section).

(4) The majority of states in the U.S. allow single owners to form LLCs (Davidson, 2000).

Cons of Limited Liability Companies (LLCs)

(1) Single member LLCs are still considered a "questionable practice" since they can cause problems with the IRS (Davidson, 2000, Limited Liability Company [LLC] section).

(2) Unlike proprietorships and partnerships, LLCs require some paperwork to form and operate (although it is minimal compared to the paperwork required by corporations) (Davidson, 2000).

(3) LLCs must be carefully set up or they will be taxed as a corporation, not a partnership (Davidson, 2000).

Finally, let us take a quick look at corporations. "A corporation is a business legally separate from its owners, meaning it is responsible for its own acts and its own debts" (Wild et al, 2007, p. 11).

Pros of Corporations

(1) Corporations have a number of owners (stockholders) so it can be much easier for these firms to acquire enough capital to start up and continue operating (Wild et al, 2007, p. 11).

(2) These companies can easily outlive their owners or personal hardships since they operate separately from their owners and thus, can rather simply be transfer from one owner to another (Davidson, 2000).

(3) Corporations only require one member to be created (Davidson, 2000).

(4) Despite the limited liability, owners still can play an active role in the operation of their business (Davidson, 2000).

Cons of Corporations

(1) Any income earned by corporations (except S corporations) is subject to double taxation. It is first taxed as corporate income and then as personal income through stockholder dividends (Davidson, 2000; Wild et al, 2007, p. 11).

(2) Articles of incorporation must be filled with the secretary of state before a corporation can form (Davidson, 2000).

(3) Corporations are under much more government control (i.e., they are required to appoint a board of directors and hold regular meetings that must be recorded and formally published) (Davidson, 2000).

(4) S corporations allow owners to enjoy some of the tax advantages of partnerships and LLCs but are required to follow a strict set of rules and regulations to qualify and continue to receive this special taxation (Davidson, 2000; Wild et al, 2007, p. 11).

References:

BusinessTown.com. (2003). Getting started - Legal structure: Pros and cons of sole proprietorship. Retrieved June 5, 2008, from http://www.businesstown.com/gettingstarted/structure-procon.asp

Davidson, S. E. (2000). LLC vs. corporation vs. partnership vs. sole proprietorship: What are they - How do they differ? Retrieved June 5, 2008, from the Limited Liability Web site: http://www.llcweb.com/struc.htm

Nolo.com. (1999). Partnership: Advantages and disadvantages. Retrieved June 5, 2008, from http://www.inc.com/articles/1999/10/14602.html

Small Business Advantages. (n.d.). Sole proprietorship: Advantages and disadvantages. Retrieved June 4, 2008, from http://www.smallbusinessadvantages.com/sole-proprietorship.html

Wild, J. J., Larson, K. D., & Chiapetta, B. (2007). Fundamental accounting principles (18^th edition). Boston: McGraw-Hill/Irwin.