How To: Choose the Best Legal Structure for Your Business
Updated: Mar 16, 2018
The legal structure that you choose for your business is one of the most important decisions that you will make in the startup phase. Each type of business entity has its own pros and cons, so it's important to sort through the different types before making a decision. It is important to figure out which business entity gives you the most advantages and helps you achieve your business and financial goals. Here's what you need to know to help choose the best legal structure for your business.
A sole proprietorship is an unincorporated business owned by a single individual or a married couple. It is the simplest form of business entity.
In a sole proprietorship, an individual conducts business and holds property in his or her own name. An owner can do business under a trade name ("doing business as" or "d/b/a") but cannot use "Inc." in the name because there is no corporation.
The law makes no distinction between the owner of a sole proprietorship and the owner's business. Therefore, the owner is responsible for all of the business' profit and debt. This entity does not offer the separation or protection of personal assets.
Quick and inexpensive
Exists the moment the owner starts doing business
Business does not file a separate tax return
Owner is directly and personally liable for debts and liabilities of the business
Absent estate planning, the business dies along with the owner
A partnership is a business entity made up of two or more persons or entities to carry on a trade or business. There are two types: general partnerships, where all is shared equally; and limited partnerships, where only one partner has control of its operation, while the other partner(s) simply contribute to and receive part of the profit. Partners can be held liable for the decisions and actions of the other partners.
Limited partner's liability is limited to the amount of investment
General partners are liable for debts and liabilities of the business
One partner is liable to third parties for debts and liabilities incurred by another partner
A 1% partner can be liable for the entire debt and liability of the business
Limited Liability Company (LLC)
A limited liability company is a hybrid structure that allows owners or "members" to limit their personal liabilities while enjoying the tax and flexibility benefits of a partnership. Under an LLC, members are protected from personal liability for the debts of the business, as long as it cannot be proven that they have acted in an illegal, unethical or irresponsible manner in carrying out the activities of the business.
Members are not personally responsible for business debts and liabilities
A corporation is an entity granted a charter by the state recognizing it as a separate legal entity having its own rights, privileges and liabilities distinct from those of its owners or "shareholders." It can sue, be sued, own and sell property, and sell the rights of ownership in the form of stocks.
There are several types of corporations, including C corporations, S corporations, B corporations, close corporations and nonprofit corporations.
C corporations are owned by shareholders and are taxed as separate entities. A C corporation pays its own taxes at the corporate rate, and profits are distributed to shareholders as "dividends." Dividends are taxed at the shareholder's individual tax rate. C corporations are subject to "double taxation."
S corporations avoid the double taxation of C corporations, and are treated as pass-through entities like partnerships or LLCs. Owners also have limited liability protection.
B corporations, otherwise known as benefit corporations, are for-profit entities structured to make a positive impact on society.
Close corporations, typically run by a few shareholders, are not publicly traded and benefit from limited liability protection.
Nonprofit corporations exist to help others in some way, and are rewarded by tax-exemption status.
Shareholders are not personally responsible for business debts and liabilities (limited liability)
Corporate entity is not terminated upon death of its owner(s)
Ownership rights can be transferred without disrupting the business
Required corporation formalities such as adopting bylaws, issuing stocks, holding shareholder and director meetings, filing annual reports and paying annual fees
A cooperative is owned by the same people it serves. Its offerings benefit the company's members, who vote on the organization's mission and direction.
Factors to Consider
For new businesses that could fall into two or more of these categories, it's not always easy to decide which one to choose. You need to consider your startup's financial needs, risk and ability to grow. It can be difficult to switch your legal structure after you've registered your business, so choosing correctly at the start is crucial.
Flexibility: Align your business goals with the proper structure. Your entity should support the possibility for growth and change.
Complexity: There is nothing simpler than a sole proprietorship. You simply register your name, start doing business, report the profits and pay taxes on it as personal income. Partnerships, on the other hand, require a signed agreement to define roles and percentages of profits. Corporations and LLCs have various reporting requirements with the state and federal governments.
Liability: A corporation carries the least amount of personal liability, since the law deems it to be its own entity. This means that creditors and customers can sue the corporation, but they cannot gain access to any personal assets of the officers or shareholders. An LLC offers the same protection, but with the tax benefits of a sole proprietorship. Partnerships share the liability between the partners as defined by their partnership agreement. Sole proprietorships offer no liability protection since the owner and business are treated as a single entity.
Taxes: An owner of an LLC and partnership will pay taxes, just as a sole proprietor does — all profit is considered personal income and is taxed accordingly. A corporation files its own tax return each year, paying tax on profits after expenses. Corporations are subject to "double taxation" when dividends are paid to shareholders.
Control: If it is important for you to have sole or primary control of the business and its activities, a sole proprietorship or an LLC might be the best choice for you. You can negotiate such control in a partnership agreement as well. A corporation is constructed to have a board of directors that makes the major decisions to guide the company. A single person can control a corporation, especially at its inception, but as it grows, so does the need to operate it as a board-directed entity.
Capital investment: If you need to obtain outside funding sources — like investor or venture capital, bank loans and other avenues for money — you may be better off establishing a corporation, which has an easier time of obtaining outside funding than does a sole proprietorship. Corporations can sell shares of stock, securing additional funding for growth, while sole proprietors can only obtain funds through their personal accounts, using their personal credit or taking on partners. An LLC can face similar struggles, although, as its own entity, it may not always necessary for the owner to use his or her personal credit or assets.
Licenses, permits and regulations: You may need specific local, state and federal licenses and permits to operate depending on the type of business and its activities. As you choose your structure, understand the state and industry you're in.
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