The legal structure of a business has a huge influence on the managerial/regulatory requirements and other strategic variables, which in turn impacts the bottom line. A proper choice of the legal structure must take into consideration capitalization, profit and loss allocation, applicable tax regimes, compensation, ownership restrictions, desired managerial control, setup and running costs and the expected future of the business (Hertz, Beasley, & White, 2009). Unfortunately, many business owners fail to appreciate the strategic importance of the legal structure or are simply unable to reconcile the determinant variables. This in turn forces owners to work under restrictive or costly form, or incur considerable costs in changing from one form to the other. This paper presents a review literature on the nature of different structures and taxation opportunities, followed by interview results from two entrepreneurs, before the conclusion that draws together varied aspects arising throughout the paper.
Hertz, Beasley, & White (2009) argues that information gaps are responsible for the difficulties by small business owners to take into consideration the implications of the legal structure. In a study involving 513 small and medium-sized business owners, Hertz, Beasley, & White (2009) sought to examine the decision-making processes by upstart owners with regard to the choice of the legal structure of the businesses that they set, including the influence of professional advice or lack thereof on the considerations and the resultant satisfaction of the structure choice. The authors established that the choice of the legal structure is a complex decision and one that’s heavily dependent on the patterns of interactions between entrepreneurs and their legal advisors.
The results point to the fact that a huge proportion of business owners seek legal counsel on the form, with beliefs and personal concerns being among the most important factors shaping the ultimate choice of the structure. There was also little difference between entrepreneurs that sought advice and those who didn’t regarding their satisfaction with the chosen legal structure. Further, while entrepreneurs who sought advice considered liability protection and tax implications, there is no statistical significance evidence to prove that they considered any the wide range of other variables. The little difference between the two sets of entrepreneurs in the study, coupled by the relatively high costs of legal/accounting advice when setting up businesses seems to suggest that a “a hit-and-miss” approach in the choice of the structure is just as effective, even cheaper than the “proper” approach. It’s interesting to determine if costs of legal advice at the onset can offset the opportunities for entrepreneurs to gain from legal decisions. Of course, the small number of possible structures makes it fairly possible that entrepreneurs will still choose the right structure. Hertz, Beasley, & White (2009) bears indirect evidence to this assertion.
Seidman (1986) asserts that every business structure has its strengths and difficulties about the applicable taxes and that the choice of the proper structure is dependent on every business’ unique strategic context. The message in Seidman (1986) seems to reinforce the limitations in Hertz, Beasley, & White (2009)’s assertions that technical advice may be helpful, not least because a complex set of factors and their interaction apply, and even advisors are just as likely to get it wrong. Businesses with a relatively small income are better suited as partnerships, while those with incomes of more than $60,000 are better of as corporations. Seidman (1986) also points to other variables such as the amount of salary that proprietors draw way from the business and the manner in which capital losses and gains are assessed for a specific legal structure. While this article lays out the varied differences with regard to taxation between different structures, it avoids Hertz, Beasley, & White (2009) findings that taxation is only one aspect of the decision making process, and that entrepreneurs also assess exposures due to liabilities, financing and other factors in decision-making. Further, Seidman (1986)’s paper ignores the interaction of (taxation) and other variables, including the expected optimal structure for a business, and the costs (or ease) of changing one structure to the other.
Yaacob, Ismail, Awang, Said, & Jusoff (2009) tries to overcome the gaps in Seifman (1986) by narrowing down on the narrow considerations regard to accounting for partnerships. The paper begins with a comprehensive overview of the nature and types of partnerships, strengths and weakness, which reflect those identified by Seidman (1986). Yaacob, Ismail, Awang, Said, & Jusoff (2009) gives a helpful insight into the accounting procedures and principles involved in partnership accounting. It highlights the importance of capital accounts, effects of dissolution or retirement of partners among other factors. While this article does not speak directly to the findings in Hertz, Beasley, & White (2009), it highlights a wealth of nuances that would be extremely difficult for average entrepreneurs to understand. This is even more emphasized by the fact that both Yaacob, Ismail, Awang, Said, & Jusoff (2009) and Seidman (1986) only considered the taxation aspect of the business structure. It is difficult to think that when all these factors are put in front of an upstart entrepreneur or even accountant, they will be able to decide on the best structure. Effectively, Hertz, Beasley, & White (2009)’s finding that there was no marked difference in satisfaction between entrepreneurs who engaged the services of legal/accounting counsels and those who did not.
Interview Results & Findings
The interview results confirm and go beyond the findings by Hertz, Beasley, & White (2009). While the respondents did not receive any technical advice on the choice of the legal structure, it is evident that they did not consider the structure as overly important at the time. It is interesting that the respondents considered that other factors in their business models had greater strategic importance than taxation gains. Even most revealing, both the respondents fo not believe they can change their structures just because of tax benefits. However, the reasons given for the choice and/or suitability of the current business structures are reflective of Hertz, Beasley, & White (2009) including ability to control, liability protection, ownership structure, and cost of technical consultation. Nearly similar factors remain relevant at the decision as to whether they should move from one structure to the other.
The business structure has critical strategic implications (management, flexibility and applicable taxation and regulations), but there is clear evidence that some entrepreneurs do not believe these gains are significant. It is evident that the cost of technical advice and failure to consider or ignorance of the entrepreneurs regarding the strategic implications of a structure outweighs the need to make these key decisions. There is also evidence that the decisions involved in the choice of a proper structure are too complex, nuanced and intricately related than is possible to get exactly right, which may also be the reason why some entrepreneurs do not consider them important.
Hertz, G. T., Beasley, F., & White, R. (2009). Selecting a Legal Structure: Selecting Strategic Issues and Views of Small and Micro Business Owners. Journal of Small Business Strategy (Bradley University) Volume 20, No. 1, 82-101.
Seidman, J. S. (1986). A comparison of tax advantages of a corporation v. partnership or sole proprietorship. Journal of Accountancy 950; 90, 000002; ABI/INFORM Global.
Yaacob, Z., Ismail, J., Awang, N., Said, R. H., & Jusoff, K. (2009). Interdisciplinary. Journal of Contemporary Research In Business 1.6 , 102-19.