Choosing the Right Business Structure for Your Startup
Every decision you make about your business during the initial stages has a significant impact for the future. While determining the nature of your business, its name, location, and target audience are all important components of developing a business, deciding on a business structure is equally crucial. This topic is especially relevant during tax season because the structure of your company has immediate tax implications. There are legal and tax implications to every business structure. It’s something that should be done and organised before your business is registered.
This article will act as a comprehensive guide to determining the best business structure for you.
What are the Common Business Structures?
There are four common business structures often chosen by business owners: Sole Proprietorship, Partnership, Company, and Corporation.
Sole Trader
The simplest out of the four business structures is the sole proprietorship also know as sole trader. This structure is simple and ideal for most small business owners, such as contractors, performers, online merchants, and home-based startups.
As a sole trader, you will manage and run your company under your name. You gain complete control of the company and are responsible for all business decisions.
All of the business assets and liabilities are not separate from the sole trader's (Your) assets and liabilities. This is due to the fact that sole proprietorships do not generate a separate business entity. As a result, they may also be personally accountable for their debts and liabilities.
HOW ARE SOLE TRADERS TAXED?
Since it simply requires a single individual running their business, this is the cheapest and simplest business structure. In terms of taxation, sole proprietorships are classified as a "pass-through entity" or "flow-through entity," which implies the company pays no taxes. Instead, taxes are transferred to the owner, who pays them on Tax Day in their returns at regular income tax rates.
Sole traders report their business income on their income tax returns and pay the same tax rate as individuals. The sole trader will pay more tax if the business earns more money. In Australia, for example, if a sole proprietorship's annual income is less than $18,200, the business is exempt from paying tax. However, if the business generates more than $180,000 in a year, the sole trader may be required to pay more than $54,000.
Personal services income, or PSI, is earned when a sole trader earns more than 50% of their contract income from their labour, talents, or knowledge. In this situation, individuals must answer particular questions on their tax returns, which may impact the deductions they claim.
Partnership
A partnership is a group of two or more people who work together to run a business. It is the most basic structure allowing two or more people to own a business together. This structure is both straightforward and cost-effective. The three types are general, limited, and limited liability partnerships.
General partnerships are the most basic type of partnership, and they're also the easiest to maintain. This business structure involves two or more people working together to run a business under a company name. All partnership members have unlimited liability and equal influence over management decisions.
A general partnership usually does not require any formal paperwork; the business is formed immediately after the partners begin the business activity, and it is therefore simple to dissolve.
Because all partners in a general partnership have unlimited liability, the company is not a separate legal entity, and the members' assets are entwined with the company's assets. As a result, their assets can be used to pay out the company's debts in the event of bankruptcy.
Limited partnerships provide more security to each party. At least one general partner has unlimited liability, whereas the other partners' liability is limited. The partner with unlimited liability has more control over the business than the other partners.
Profits from the business are divided among the partners based on how much each has invested. Unlike general partnerships, which require very little paperwork, this business structure necessitates some documentation.
In a limited liability partnership, all partners are protected from the actions of the other partners in this type of partnership. This business structure differs from a limited partnership where at least one partner must have unlimited liability.
In the US for example, only some professionals, such as lawyers, doctors, and accountants, can form limited liability partnerships in most states. As a result, before deciding on this form of business structure, make sure to examine your country/state's regulations.
Regardless of the sort of partnership you choose, it is critical to draft a partnership agreement which is the bedrock of all partnerships. The agreement should outline how the company will run, particularly resolving conflicts and allocating earnings. A partnership agreement must also describe how a partner's stake should be passed upon instances like death, as well as the financial contribution of each partner.
How are Partnerships taxed?
Partnerships, like sole proprietorships, are considered pass-through entities regarding taxation.
Personal service income can be earned similarly to sole traders; however, deductions on this income may need to be addressed differently. Each partner must pay tax at their individual tax rate on their portion of the business’s net income. A yearly partnership return detailing the business's income and deductions is also required.
Company
A company is a legal entity founded by a legal person or a group of legal persons to engage in or carry on a business or industrial venture as an artificial legal person.
A company's public or private status is determined by the number of people who can purchase its shares. The ownership of shares in a public business is available to the general public; hence the number of members of a public company is unrestricted.
A private company's shares, on the other hand, cannot be owned by the general public; it limits the number of members and denies members the opportunity to transfer shares.
How are companies taxed?
A company is a distinct legal entity with higher startup and administrative expenditures. Companies must pay income tax on their profits at the corporation tax rate, which varies according to state and country rules. If the standards for personal service income apply, the income will be taxed as individual income. It's also possible that claimed deductions will be affected.
Limited liability companies (LLCs) are considered state entities, they receive special tax treatment from the federal government. A single-member limited liability company is usually taxed as a sole trader, but a multi-member limited liability company is often taxed as a corporation.
Corporation
A Corporation is a type of company seen as a single entity and recognised by the law for certain purposes. Corporations can profit, pay taxes, and be held legally responsible. They provide the best protection from personal liability for their owners, but they are more expensive to incorporate than alternative structures. There are four common types of corporations; C Corp, S Corp, Non-profit, and Trust.
How are corporations taxed?
Corporations are divided into two types for tax purposes: "C corporations" and "S corporations."
A "C corporation" or "c Corp" is considered the standard categorisation for corporations. When filing certificates of incorporation with the state's legal business registration bureau, all corporations begin with the "C" category. Unlike the previous business structures in this article, C corporations are not pass-through entities.
They are liable to corporate income tax, and their owners or shareholders are also required to pay individual income tax on earnings, a practice known as double taxation. Double taxation is when a company is taxed twice at the corporate level and then again at the personal income level after being dispersed to shareholders.
An S corporation or "s Corp" differs from a C corporation. It is a pass-through business that avoids double taxation. In most nations, however, there are stringent requirements for organisations seeking S company status, particularly when it comes to shareholders. An S corporation, for example, can only have 100 shareholders, all of whom must be citizens or residents of the respective nations.
Trust
A trust is a financial institution that works as a trustee or administrator for corporations or persons. It may be a component of a traditional bank. A trust company's services to corporations include functioning as a stock transfer representative and managing fiduciary connections.
How are trusts taxed?
A trust company's typical job for individuals involves administering trust assets. Because the beneficiaries who receive the trust's net income are individually assessed for tax, a business run through a trust is not liable to pay tax.
If the trust earns marginal trust profit and fails to share it, it is taxed on the accumulated income at the highest individual rate. The trust's revenue and the income distributed to each beneficiary must be reported on their tax returns each year.
How are Digital Companies Taxed?
In recent years, tax arguments have centred on the economy's digitisation. These arguments have focused on the disparities in taxing physical and virtual corporate operations as companies traditionally required a physical presence to be taxed.
Companies can, however, make significant revenues without having a physical presence in this digital era by using their user base, data, and advertising. Users of these services provide value in data, which platforms can subsequently sell to third parties. Still, there is no method to apply corporation tax to this value due to the old-fashioned tax structure.
After conceding that the existing international tax structure is ill-suited for digital, the Organisation for Economic Cooperation and Development (OECD) has found numerous approaches to tax the digital economy through the BEPS (Base Erosion and Profit Shifting) project enterprises.
The OECD suggests levying a digital service tax (DST) on enterprises that rely on user participation in digital activities and data collecting for targeted advertising to generate revenue. This tax will be imposed at a rate of 3% on gross income for companies with yearly financial revenues exceeding €750 million.
Another method for taxing digital enterprises is the digital presence directive, which taxes businesses based on their digital presence rather than their physical presence.
Factors to Consider when Choosing a Business Structure
Certain factors must be considered prior to selecting a business structure; some of these include:
Size of the Business
The number of people involved in your company might help you determine what business structure is best for you. If you're working alone, a sole proprietorship might save you a lot of money in legal expenses and paperwork.
If you're hiring an entire staff team, you might be interested in the legal protection that more advanced choices provide.
The Cost of Starting the Business
There are higher costs associated to registering a business as a company or a Corporation.
Form of Liability
When you start a business, you are more vulnerable to legal action than when you worked for someone else.
Your liability is determined by the business structure you pick. Some business structures can jeopardise your assets and income. Others provide personal security while using your company as a barrier against legal action. It will be easier to select the correct structure for your business if you know what kind of coverage you require.
tax considerations
As discussed above, different types of legal business entities are taxed in different ways and that’s something you should consider and consult about to determine the best option for you.
the wrap up
Every decision you make about your business when first starting out is just as important as the next. Sole proprietorship, partnership, company, and corporation are entrepreneurs' four major business structures. Every business structure has legal and tax implications. As a result, it's vital to understand these implications before deciding to start a business so that you can avoid potential pitfalls. Start as you mean to go on and choose the right one for you.