If you’re thinking of starting a business, you can structure it as a sole proprietorship, a partnership, or a corporation. Each of these options has slightly different implications for tax and financing. It’s therefore important to choose the right option for you and your business. Here is a quick guide to what you need to know.
Company structures 101
In a sole proprietorship, you are your company. This means that you will use consumer-facing products rather than business-facing ones. For example, you will have a standard checking account rather than a business one.
Any income you generate through your business will be considered personal income and taxed accordingly. Likewise, any debt you take on to grow your company will also be considered yours. You can sell your goods and services to other people. You cannot, however, sell your company itself because it is a part of you.
Partnerships are very similar to sole proprietorships. The key difference is that they involve two or more people. This means that there needs to be a legal structure in place to clarify each partner’s benefits and obligations. There also needs to be a process for a partner to exit the partnership.
Corporations are considered legal entities in their own right. This means that any income generated by the business is owned by the business. Likewise, generally, any debts held by the business are the responsibility of the business, not the owners or employees.
Working as a sole proprietor
The great advantage of working as a sole proprietor is that it keeps life simple. You collect your income, file your regular tax returns and pay what you owe as usual. The disadvantage of working as a sole proprietor is that it really limits your flexibility.
For example, you cannot sell part of your company, or use it as collateral, because you are your company. Similarly, you cannot use stock options to attract new employees because you do not have stock.
How big of an issue this is in practice depends very much on what kind of company you are. For example, if you’re a knowledge worker and you just want to earn an income from your skills, it’s unlikely to be an issue. If, however, you have ambitions to grow a company you can sell (or pass) on, then it could be a major stumbling block.
Working as a partnership
Essentially the same comments apply to working as a partnership. These are common in some areas, for example, the law. Overall, however, they tend to be very niche. In fact, it often makes a lot more practical sense for sole proprietors to cooperate and pool resources informally than it does for them to form an official partnership.
Working as a corporation
Working as a corporation does involve a lot more administration than working as a sole proprietor. That administration comes at a cost. The benefit, however, is a lot more flexibility in how you run your company.
For example, you can choose between keeping money in a company or withdrawing it.
You can get financing in your company’s name (rather than yours) and you can share ownership of it. That doesn’t have to mean going down the path of GIPS verification and investment rounds, although it can. It can be as simple as giving a stake to other family members as an advance on their inheritance.