Why businesses choose different structures

You don’t sell in a flea market environment.  Neither does your client.  If you did, you and the business would be considered the same entity.  If you sold someone a used cappuccino machine and it exploded, they would come after you personally in court.  For this reason, people in business take deliberate steps to separate their personal finances from their business activities as a means of personal protection.  What structures do they use?

First, you must understand the government has a keen interest in being your silent partner.  You take the risks and they take a share of the profits your business produces.  They give you plenty of opportunity to recycle money growing the business, but they expect their share of your profits.  This keeps accountants in business.  All businesses need good accountants.

The corporate structure is the most obvious form of organization.  Almost any large listed company you can name is organized in this way.  A major problem with this structure is the concept of double taxation.  Let’s suppose the business makes money after paying expenses.  This profit is taxed by the government.  The tax rate is 21% (1)  But the money is still held within the corporation.  It leaves the business and goes into the shareholder’s hands through the payment of dividends.  These are taxed as income on the individual’s tax return.  That’s what’s meant by double taxation.  The corporate structure, although complex and expensive can allow for various benefits to be provided by the corporation to its employees.

The most important benefit of this (and other) business structures is the corporate veil or the protection from personal liability.

The Limited pPartnership or LP structure  is a way for a few people to do business together.  There is often a general partner and limited liability partners. 

A more familiar term is the Limited Liability Partnership or LLP structure.  In this case, all partners have the same level of personal protection.

You’ve heard the expression Limited Liability Company or LLC before.  Its structure is similar to the LLP above.  A key benefit of this structure is the avoidance of double taxation.  Profits in the business are distributed directly to the partners or owners, which are then taxed at their personal income tax level.

You’ve also heard of S Corporations, which provide some of the benefits of the corporate structure with the benefits of the pass-through structure of partnerships.  Profits from the business (losses, too) channel directly through to the owner, who pays taxes at their individual rate.

The last structure we will look at is the Sole Proprietorship.  This is where you are the company and vice versa.  There is no corporate veil between your business and personal lives.  In this situation, profits are taxed as personal income.

The advantage of the corporate veil

No one wants to be held personally liable if it can be avoided.  For this reason, businesses are often set up as arm’s length relationships.  If the business fails, under ideal circumstances you don’t want to be held liable for its debts. 

In reality, a bank lending to a new business will want your personal guarantee before they put their money at risk.  Butr for the big issues, the structure provides protection.

But you must walk the walk and talk the talk.  The flea market vendor operating out of his own pocket cannot claim it was a separate business that sold the exploding cappuccino maker.

1. Incorporation.  The business needs to be formally established, structured and registered with the state. 
2. Filings.  The business needs to file tax returns and other documentation, separate from your personal returns.
3. Bank accounts.  The business needs ones separate from your personal accounts.
4. Line of credit.  It’s awkward lending your own money to the business whenever it’s needed.  You want the business to have the ability to borrow when needed for short periods.
5. Credit card.  You will have business related expenses.  These should also be arm’s length.
6. Expenses.  There will be times when you spend personal money on business expenses.  Using your personal car when driving to the airport is an example.  You need to document reimbursable expenses.
7. Telephone.  If you are your business are two separate entities, you need a phone number for the business entity too.

It’s important to understand these structures if you are setting up your own business.  It’s also important to understand why your small business clients choose the structures they do.  In all cases, if you are going to be in business, you need a good accountant.

Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor” can be found on Amazon.

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