Types of business structure

Business structures and their effects

Most small businesses are structured as a sole proprietorship, partnership, limited liability company (LLC) or limited liability partnership (LLP). Your choice will affect your admin burden, tax and legal status.

If you don’t choose a business structure

If you don’t choose a structure when starting a business, you’ll be assumed to be a sole proprietor. That’s how a lot of people start out. However, it’s worth understanding what it means to be a sole proprietor, and getting your head around the other structures. Speak to a lawyer or accountant before making any changes.

What is a sole proprietorship?

A sole proprietorship is a single-owner business. It doesn’t have to be a single-worker business, so you can hire staff.

Advantages of a sole proprietorship

It’s easy to set up as a sole proprietor and tax is simple. You just declare income on your personal tax return.

Disadvantages of a sole proprietorship

A sole proprietorship doesn’t have any special legal status, which means the owner is personally responsible for what the business does. If the business gets into debt or legal trouble, so does the owner. Your choice of insurance becomes very important.

What is a partnership?

A partnership is owned by two or more people. There are no rules about how it’s divided. One partner can own 99% of the business.

Advantages of a partnership

It’s easy to set up as a partnership, though you’ll need an official letter that sets out the agreement between partners. Tax is simple too. You just declare your share of business income on your personal tax return.

Disadvantages of a partnership

If the business gets into financial or legal strife, the partners do too. You could also get into difficulty if one of the other partners does something wrong. Your choice of insurance becomes very important.

What’s in a partnership agreement

A simple business partnership agreement should:

• state the legal name of the partnership and say what you do
• name the owners and show how many shares each has
• appoint a primary business officer
• say when and how income is distributed among the partners
• include a process for resolving disputes
• identify how bookkeeping and finances will be managed
• outline how the partnership can be wrapped up (and how debts or profits would be distributed)

As you can imagine, even a simple business partnership agreement can get lengthy and complicated. Search the internet for examples or, better still, ask an accountant or lawyer to help.

What is an LLC (limited liability company)?

An LLC is legally separate from its owner (or owners), which means you’re less exposed to legal or financial risks. An LLC can be owned by one person or many.

Advantages of an LLC

You get some legal and financial protection if things go wrong – a lawyer can give you the lowdown. Banks and investors sometimes take companies more seriously when considering loans. And tax can be as simple as it is for sole proprietorships and partnerships.

Disadvantages of an LLC

It will cost you more to operate as an LLC than as a sole proprietor or partnership, plus there will be more admin.

LLCs and tax

The IRS doesn’t have a single set of rules for how to tax LLCs. If you’re an LLC with one member, the IRS will treat you as a sole proprietorship. If you have more than one member, you’ll be treated as a partnership. Or you can elect to be taxed as a corporation (irrespective of how many members you have).

What is an LLP (limited liability partnership)?

An LLP is designed to protect a business owner from the malpractice or negligence of a partner. It’s a popular business structure in industries like law, medicine, architecture or accountancy, where mistakes may carry heavy consequences.

Advantages of an LLP

You’re not as badly affected if the business or one of your partners makes a mistake. Banks take you more seriously. Business income can be simply dealt with on your personal tax return.

Disadvantages of an LLP

The legal side of things can get quite complex and you may have to take out some costly insurance policies. There’s a lot of admin and paperwork to do.

You can change your business structure

You’re not locked into one structure forever. A lot of businesses start out as sole proprietorships or partnerships and grow into LLCs, LLPs, or corporations. You might change your business structure if you start getting bigger and doing more complex projects which carry a greater financial or legal risk for you.

Where do franchises fit?

If you buy into a franchise, you don’t automatically become part of their business. You form your own business and enter into a deal with the franchisor. You may be able to choose your own business structure, or the franchise agreement may require it to be set up in a specific way, such as an LLC.

Disclaimer: Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the provided content.