In this series of articles, I will post ten simple ideas from chapters in The Ernst & Young Business Plan Guide (3rd edition). This third post in the series brings out ten simple ideas from Chapter 3, Legal forms of a business.
Introduction
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The third chapter of The Ernst & Young Business Plan Guide (3rd edition) is called, Legal forms of a business. This chapter compares and contrasts a variety of business structures, including sole proprietorship, the partnership, the limited partnership, the limited liability company (LLC), the C corporation, and the S corporation. Since the book was written in 2007 and the Benefit Corporation (B corporation) wasn't established until 2010, that corporate structure is not included in the chapter.
The remainder of this post will describe ten simple ideas from the chapter. This is a very dense chapter, so this post is not necessarily comprehensive. I highly recommend reading the chapter.
Ten Simple Ideas from chapter 3 - Legal forms of a business
1.) There is a trade-off between minimizing taxes and organizational complexity.
The chapter gave the examples of a family business on one hand and a venture-funded firm on the other. The family business expended great time and effort creating a complex business structure that shielded them from many taxes. The venture-funded firms erected a simpler, less costly business organization, but accepted a higher tax burden.
The point of all this is that organizing to avoid taxes creates complexity, which is also expensive. The chapter gives the rule of thumb that:
you can't let good tax planning overtake any other business reason that you may have, and you can't let tax planning stand in the way of making good business decisions.
2.) There are four major variables that the entrepreneur needs to consider when choosing a business structure: liability, control, ease of bringing in new investors, and taxes.
The following ideas will go into more details on each of these factors. Here is a brief summary.
Liability: Is the entrepreneur responsible for debts that are incurred by the company? Some of the business structures discussed limit the liability that an entrepreneur may face. Others leave the entrepreneur with unlmited liability.
Control: This has to do with who is empowered to make decisions. It can run the gamut from control by a single person to agreements among partners to control by shareholders and boards of directors.
Ease of bringing in new investors: Even if you are launching a business out of your garage, you may eventually need to seek additional funding. This is frequently done by selling ownership shares. Some of these business structures make it harder or easier to raise investment funding.
Taxes: In the US, taxes must be managed at state and federal levels, and they can be simple or complicated based on business structure. In some business structures, income may be taxed twice, once as income when it is earned by the business and again as "capital gains" when it is liquidated. In that "feature" of taxation, the US is apparently unusual around the world.
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3.) The primary vehicle for avoiding liability risk is through the use of insurance. Business structure can provide a secondary line of defense.
In some cases, it is unavoidable that the entrepreneur put his own possessions and capital at risk, but the goal is to avoid risk from things that are outside of the owner's control. Under sole proprietorship, partnership, and limited partnership, however, the owner's liability is unlimited. In contrast, in a limited liability company (LLC) or corporation, the owner and shareholder liability exposure is limited.
4.) The control of the organization can be directed by ownership, partnership agreements, or by a board of directors.
In a sole proprietorship, there are no issues of control because there is a single person in charge. In a partnership or limited partnership, it is necessary to draw up a partnership agreement. In an LLC or corporation, an operating agreement describes the control schemes. In a corporation or S corporation, control is exercised by the shareholders through the officers and board of directors.
In some cases, a lender may also wish to exercise a degree of control, regardless of business structure. This can be accomplished through the use of a loan agreement.
5.) Even a business launched in a garage will eventually need to bring in investors. Entrepreneurs need to plan for that capability in advance.
Basically, the more complicated a business structure, the more difficult it will be to bring in more investors. To bring in new partners, partnership agreements need to be modified, which requires buy-in from existing partners. Issuing new shares in a corporation requires shareholder approval and it comes with tax and regulatory implications.
To avoid a cash crunch, the entrepreneur needs to be planning for these eventualities well in advance.
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6.) Taxation is a complicated subject, and experts should be consulted, but the tax implications of the business structure should be understood when the structure is selected.
As noted above, the publicly traded corporation subjects its income to double taxation. It is taxed once as corporate income, then again as a capital gain for the investor. The simpler business structures do not subject income to double taxation.
At the end of the chapter is a table of the characteristics of the different business structures (Table 3.1, pp 53-55). These last for ideas summarize information from that table.
7.) A sole proprietorship has the simplest structure and tax situation, but the owner's liability is unlimited.
In a simple proprietorship, the owner has complete control of the business, but also faces unlimited liability. Taxation is paid as a form of individual income tax, which means that the business income is not taxed twice.
8.) A partnership also has a relatively simple structure and tax situation, and also has unlimited liability risk. It is necessary to delineate control through use of a partnership agreement.
In a partnership, control is managed through a partnership agreement. Full partners face personal liability risk whereas limited partners only face financial liability. Taxation for the partners is handled as a form of personal income tax, so business income is only taxed once.
9.) A limited liability company (LLC) has a moderately complex structure and tax situation with limited liability for owners and some tax advantages over corporations.
In a LLC, control is managed through an ownership agreement. Owners are legally shielded from some forms of liability. Members are taxed as personal income, so business income is not taxed twice.
10.) A corporation has a complex structure and tax situation. Owners are protected from liability. The company is controlled by shareholders. Income may be subject to double-taxation.
A corporation can take the form of a C corporation or an S corporation. Because most companies are C corporations, this is what we usually think of when we talk about American businesses. The S corporation is a similar structure, but it is incorporated for all purposes except taxation.
In the corporation, control is exercised by the shareholders through the corporate officers and board of directors. Shareholders are legally shielded from liability, but corporate officers may face some amount of liability. For the S corporation, shareholders are taxed as a form of personal income tax, so the business income is not taxed twice. For a C corporation, the corporation is taxed for income, and the shareholders are taxed for capital gains, so the business income does get taxed twice.
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Conclusion
In this post, we have reviewed ten simple ideas from the third chapter of The Ernst & Young Business Plan Guide (3rd edition), Legal forms of a business. This is a very dense chapter, so I highly recommend reading it directly.
The key point from the chapter is probably that the entrepreneur needs to consider many factors and choose a business structure that will balance among four factors: liability, control, ease of bringing in investors, and taxation.
This chapter predated the Benefit Corporation (B corporation), so in addition to the discussion above, the modern entrepreneur also needs to consider that as a possible business arrangement.
Check back soon for ten simple ideas from chapter 4, Due Dilligence.
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Previous Articles in the series
- [Ten Simple Ideas] The Ernst & Young Business Plan Guide: Chapter by Chapter - Series Overview and Chapter 1
- [Ten Simple Ideas] The Ernst & Young Business Plan Guide: Chapter by Chapter - Chapter 2 - Who Reads the Business Plan?
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