Ownership Structure and Formation of a Small Business

    

July 28, 2008 by Martin  
Filed under Martin

Who’s really in charge and where does the peso actually stop in your small business?

The answer to these questions can only be found when you formally organize and legally register your small business. In the Philippines, for-profit small businesses can be legally opened in three ways. They can be formed as a sole proprietorship, as a partnership, or as a corporation. Each form is different in its characteristics, advantages, and disadvantages. The form you choose will not only determine the amount of paperwork and cost involved in forming your business, but also other things like the amount of government regulation you will be exposed to, the manner in which you will be taxed, the way in which profits or losses can be used or dispersed, and the liability incurred by different individuals listed as owners, partners, or shareholders in the business.

A sole proprietorship is the easiest form of business to register in terms of documentary requirements and costs involved. Foreign nationals cannot form a sole proprietorship on their own, but if married to a Filipino, then the business may be registered and opened in the Filipino spouses’s name. The requirements involved in registering a sole proprietorship include filing your business name with DTI, registering for tax purposes with BIR, and securing some basic local government permits (i.e. mayor’s permit), all of which are easily obtained. The total costs vary depending on the municipality and kinds of permits needed, but a sole proprietorship is by far the cheapest and quickest way to go for most small businesses.

A business registered as a sole proprietorship has some key advantages that make it a very appropriate option for small business owners. The biggest advantage is that once registered, the business becomes an extension of the person who registered it. What do I mean by that? Well, legally, there is no distinction between the person and the business. This means that a sole proprietor is the ultimate owner, and all decisions made rest solely with the owner. All decisions made and any profits gained by the business can be used at the discretion of the registered owner. In other words, a sole proprietorship places all the power and responsibility in the owners’ hands and rewards the owner with all the potential gains to be made. The major drawback is in terms of liability. While a sole proprietor can reap all the potential rewards of being sole owner, he/she must also bear unlimited liability for the business. Philippine law does not distinguish between business and personal assets when you form a sole proprietorship, so personal non-business property can be exposed to litigation in the event of a case being filed against the business. Another drawback to consider is that you will not have access to the resources a partnership or corporation provides (i.e. additional skills and expertise, financial backing, etc.).

Partnerships and corporations offer different sets of advantages and disadvantages. Both need to be registered with the SEC and this means a great deal more in terms of documentation and fees to get set up. Partnerships have two or more owners and therefore require a different kind of legal arrangement. In the case of a partnership, at least one partner must assume unlimited liability, while other members can assume proportional liability. Partnerships operate according to a binding contract that outlines who is involved, what is contributed by whom, and how profits and losses are proportionately shared. Partnerships are an attractive option in a number of cases. You have the advantage of pooled resources, which can mean financial contributions and/or technical contributions. People new to a market can form a partnership as a way of entering the market and tapping local knowledge and contacts to help give the company an edge it may not otherwise have if it had chosen to enter the market on its own. For foreigners, a partnership can be especially appealing because it can mean having a local point person that is capable of handling ‘front-office’ issues, while the rest of the partners concentrate on ‘back-office’ issues. There are disadvantages to partnerships. Sole proprietorships allow complete control over decision-making, but in a partnership, members must be willing to share decision-making or agree to have a managing partner that handles all but certain decisions entertained by the partnership. You are also limited to a proportion of any potential profits. And finally, you could encounter tensions in the partnership if there is disagreement over company direction, especially when expansion or contraction is an issue facing the company.

Corporations are yet another option in business formation. The most appealing aspect of a corporation is that the business becomes its own separate entity that is distinct from its stockholders. What this basically means is that the corporation assumes its own liabilities and cannot transfer these liabilities to the stockholders. As an investor in a corporation, you are only risking your investment and cannot be held personally liable for any wrongdoings of the company beyond what you invested. There is however a great deal of paperwork to be completed when forming a corporation. Articles of incorporation need to be formulated, the fees involved in setting up a corporation are much higher than other business forms, yearly reporting records must be made and submitted to the SEC, taxes are higher than those paid by sole proprietorships, a board of directors needs to be established, etc. In short, opening a corporation has the advantage of limiting liability, but adds on a lot of complexities to running a business that may not be worth the time and effort for a truly small business operation.

So which form of ownership do most foreigners choose when organizing their small business? Generally speaking, those married to a Philippine national choose the sole proprietorship route, with their spouse being the person ultimately responsible for the company. This is done for most small businesses because there is little or no need to go through the elaborate expense of forming a corporation for small or hobby businesses. That being said, when very large amounts of capital are involved, the formation of a corporation is usually chosen. Foreign nationals can legally own a proportion of a corporation, and this way they can be assured they will retain ownership of at least a portion of the business and have legal standing. There are other reasons to choose to open a corporation, such as being able to apply for an investor’s visa and being able to repatriate funds relatively easily.

When you do decide to register your business, keep in mind the above advantages and disadvantages. Every small business has different needs, especially at start up. Your business may grow to be hugely successful, but that doesn’t mean you need to start out as a corporation. It is completely plausible for a business to start out as a sole proprietorship and evolve into a corporation. You can always go through the process of incorporation after you have grown your small business and your needs change.

Good luck, and no matter what form you choose, always remember to follow the reporting and tax requirements appropriate to the type of business you ultimately choose to form!

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About the Author:  Martin is an expat businessman based in Butuan City. Martin writes about business related topics here on LiP for those who want to engage in business here in the Philippines.