Choosing a business structure: a general overview

Imagine two friends who have been selling handmade furniture at weekend markets. Orders are picking up, a local shop wants to stock their pieces, and someone has asked whether they invoice as a company. Until now the business has been a shared bank account and a lot of trust. The question of what kind of business they actually are has arrived before either of them has thought about it.

Choosing a legal structure can feel like a box to tick on a registration form. In practice it shapes who is responsible if something goes wrong, how profits are taxed, how much administration you take on each year and how easy it is to bring in a partner or an investor later. It is worth an hour of thought before you choose.

The broad families of structure

The names and details differ from place to place, and in the US from state to state, but most systems offer some version of the same few options.

• Trading on your own, often called a sole trader or sole proprietor. It is usually the simplest to start, but there is generally no legal separation between you and the business, so its debts can become your debts.
• A partnership, where two or more people run a business together. How responsibility is shared depends on the type of partnership available where you are and on what the partners agree between themselves.
• A limited liability company or a similar form. This is a separate legal person, usually designed to keep the owners' personal assets apart from the business's obligations, though that protection has limits and conditions.
• A corporation or company limited by shares. Often the most formal option, with more rules on meetings, records and reporting, and frequently the structure outside investors expect to see.

A term worth knowing is limited liability. In plain language it means that, in general, the owners' risk is limited to what they have put into the business, rather than everything they own. It is a protection, not a promise of safety: personal commitments, such as signing a loan in your own name, can still reach you.

Questions to answer before you compare

Comparing structures in the abstract rarely helps. It is easier to start with your own plans and see which options fit them. These questions cover most of what matters.

1. Are you starting alone or with others, and will everyone contribute the same money and time?
2. Could the business take on debts, contracts or risks you would not want to carry personally?
3. Do you plan to raise money from investors, and if so, what kind of investor and roughly when?
4. How much ongoing administration, such as annual filings, meetings and record-keeping, are you willing to handle?
5. Will you trade in more than one state or country, now or soon?
6. Do you want to pay yourself a salary, take a share of the profits, or reinvest most of what you earn?

A structure is easier to choose well at the start than to change once contracts, staff and investors depend on it.

Tax is part of the decision, not all of it

People often pick a structure because they have heard it saves tax. Sometimes it does, depending on the business and the place, but tax treatment is only one factor and it changes as the business grows. A structure that looks efficient in year one can be awkward when you want to hire, borrow or sell. Ask an accountant or tax adviser to look at the tax side alongside the legal side, rather than letting either decide alone.

If you are starting with others

Whatever structure you choose, people who start a business together should agree in writing who owns what, how decisions are made, what each person is expected to contribute and what happens if someone wants to leave. These conversations feel awkward when everyone is excited. They are much harder once money, customers and disagreements are involved.

Back to our two furniture makers. Before choosing a structure, they would do well to write down who owns the tools and designs they already have, how they will split profits, and what happens if one of them moves away. Those answers point towards the structure that suits them, and they will need to be recorded in the founding documents either way.

Common mistakes

• Registering a company in a hurry using a template that does not match how the business will actually run.
• Mixing personal and business money, which can undermine the separation a company is meant to provide.
• Forgetting the ongoing obligations that come with a more formal structure, such as filings and records.
• Assuming a structure that worked for a friend's business will work for yours.

Where to go from here

Liability, tax treatment and the steps to set up a business all depend on where it is formed and where it trades. A lawyer can compare the options that exist in your location against your plans. If you already know the structure you want, ArieFirm's business documents cover formation and ownership, and you can complete many of them yourself.