Selecting a legal structure for a business is one of the first things you’ll have to do when you decide to start one. This is an exciting but potentially hazardous time for entrepreneurs. There are many things to consider, from creating a business plan, to establishing financing, to figuring out how your business should run legally.Choosing a legal structure for your business is critical because your decision determines how you will be taxed, how much control you will have over your business, and how much personal liability you will incur, among many other things. In this post, we’ll discuss the most popular legal structures so you can confidently choose the one that best suits your needs.
Different Types of Business Legal Structures
Sole Proprietorship
A sole proprietorship is by far the simplest of all business legal structures. It’s essentially an extension of the owner, which means that the owner is solely responsible for all the company’s actions and debts. There is not a lot of paperwork because you have no partners and you do not have to create a board of directors. It is best suited for entrepreneurs who only want to start small and do not expect to take on additional partners or investors. Sole proprietors have complete control over their businesses and can remove themselves as the owner whenever they please.
A sole proprietorship is a great choice for several other reasons. It’s usually the most affordable to set up. Expenses you can anticipate are any state and federal fees, taxes, business equipment, office space rental, and any professional services or items your business might require—like attorneys, cleaning services, bookkeepers, uniforms, etc.
As a sole proprietorship, you may be eligible for specific business tax benefits, such as being able to deduct the cost of your health insurance premiums. Sole proprietorships are also relatively easy to end, if you decide to close your business. You can dissolve your business at any time, with no paperwork or announcement necessary. In fact, it’s much easier to end a sole proprietorship than it is to end a marriage!
The Downside of Sole Proprietorship
Setting up a sole proprietorship also has downsides and risks. One major concern is unlimited personal liability, meaning your personal assets are at risk if the business faces financial troubles or lawsuits.
Limited access to capital and resources is another downside. Sole proprietors may find it difficult to secure financing or attract investors due to perceived instability, potentially hampering business growth and competitiveness. It also might be more difficult to attract top-tier employees or partners due to perceived instability, which can limit growth as well.
Partnership
There are two types of partnerships: general partnerships and limited partnerships (LLP or LP).
A general partnership is when two or more people own the business, sharing management responsibilities and risk. All partners in a general partnership have unlimited personal liability for the debts, obligations, and legal actions of the partnership. This means that your personal assets can be used to satisfy the partnership’s financial obligations. A partnership could be a good setup for you if you’re thinking of starting a business with a friend or family member.
A limited partnership consists of at least one general partner and one or more limited partners. General partners manage the business and have authority over its operations, while limited partners are typically passive investors with limited involvement in management decisions. You will need a partnership agreement, and it’s in everyone’s best interest to have an attorney at least review that agreement.
Benefits of a limited partnership include sharing expertise and responsibilities with your partner(s) while limiting your personal liability, and flexibility in terms of partnership agreements and the allocation of profits and losses.
A partnership increases your likelihood of securing a business loan, as multiple owners allow banks to consider multiple credit histories. This is helpful if any of the partners have poor personal credit. Eventually your business will have its own credit score (learn about Experian’s blueprint for establishing and building business credit), but at the beginning, lenders will consider the personal credit scores of all partners.
Potential Risks of Partnerships
As in any relationship, you have to consider the potential drawbacks as well when deciding on a legal structure for a business. It’s critical to choose the right partners, and be clear on how much capital each partner will contribute from the very beginning. You must also clearly define how profits and losses will be split among partners, based on what criteria. It’s also worth talking about exit strategies and how that would work if one or more partners wished to leave or close down the business.
In general, businesses that are partnerships do not pay separate business taxes (but there are always exceptions); instead, the income is passed through to the partners’ personal income tax returns. It is possible (in your partnership agreement) to set up different tax burdens and different shares of the business income for different partners; it doesn’t always have to be split equally.
It’s important to note that Limited Liability Partnerships (LLPs) and Limited Partnerships (LPs) are not the same thing. While both are limited partnership structures, they have distinct characteristics, purposes, and legal implications. While both LLPs and LPs involve partnership structures and offer some form of limited liability, they serve different purposes.
Professionals (lawyers, etc.) commonly use LLPs and this allow partners to actively engage in business operations while enjoying liability protection. People often employ LPs for investment ventures, with general partners managing the business and limited partners providing capital but having reduced liability and involvement.
It’s crucial to understand the nuances of each structure and choose the one that aligns with your business goals and industry. You should consult with legal and financial experts to make informed decisions based on your specific circumstances. It’s an up-front expense, but one that could save you a lot of money in the long run.
The downside of partnerships
Setting up your business as a LLP or LP has its drawbacks. For LLPs, it involves complex formation and compliance processes, which can be time-consuming and costly. Additionally, partners may have limited control, leading to potential conflicts.
In the case of LPs, limited partners face restricted involvement in daily operations, making it less appealing for those seeking an active role. Attracting investors can also be challenging due to perceived risks, and LPs can be less flexible in terms of dissolution or restructuring. Both structures provide liability protection, but come with complexities and limitations worth considering.
Limited liability Company
LLCs offer both protection and flexibility, and the LLC is a popular choice for a legal structure of a business. They protect you from personal liability and provide tax flexibility similar to sole proprietorships and partnerships. However, owners (called members) are subject to self-employment taxes on their share of the profits, which can be higher than regular payroll taxes. Depending on where the business is located, LLCs may have restrictions on how long the company can exist, and their members must be permanent residents or US citizens.
Like limited partnerships, LLCs protects owners from personal liability for the company’s debts and legal actions. This means that if your company gets sued, your personal assets (generally speaking) are off-limits. Additionally, LLCs provide flexibility in management and ownership, allowing members to choose how the company is managed—either by the members themselves or by appointed managers. LLCs can have a single-member structure or multiple members, accommodating various business sizes and types.
On the other hand, dissolving an LLC can be more challenging than for sole proprietorships or partnerships, requiring compliance with state-specific regulations and potentially leading to additional expenses. While limited liability is a key advantage, it might not fully protect members if they personally guarantee business loans, which could happen if the business is just starting out and has nobusiness credit score, or if the business is a sole proprietorship. Some states impose an annual fee or franchise tax on LLCs, which can add to the overall cost of maintaining the business.
S-corporation
S-corporations are tax entities, meaning that they exist to help small businesses save money on taxes. To qualify, the business must have less than 100 shareholders and meet other IRS criteria. If you own an S-corporation, you will pay yourself a reasonable salary and, in turn, reduce your taxable income.
One major advantage of an S-corp is the potential for tax savings. Like LLCs, S-Corps are subject to pass-through taxation. This can help you avoid the double taxation often associated with traditional C Corps. Shareholders can potentially benefit from the lower individual tax rates compared to corporate tax rates. Additionally, S Corps allow shareholders to receive both a salary and distributions of profits, potentially providing tax advantages by reducing the amount subject to self-employment taxes. In other words, you can be the employee of the company (collect a salary) and also a shareholder.
S-corps have liability protection similar to other corporate structures. This separation between personal and business liabilities can provide peace of mind to shareholders. Furthermore, an S Corp structure can lend credibility to your business, potentially making it easier to attract investors, secure financing, and establish relationships with suppliers and customers.
Downsides to S-Corps
S-Corps have more specific requirements, however, including limitations on types of shares they can issue, and what types of entities can own them. Regulations constrain shareholders’ ability to offset losses against other income, which might affect investors seeking to deduct losses from their overall income.
S-corps also have a high level of administrative complexity. They must adhere to specific formalities, such as holding regular meetings, keeping detailed records, and complying with state-specific regulations. Failing to meet these requirements could risk the company’s S Corp status and result in tax consequences. Furthermore, S Corps might have limitations on raising capital by issuing different classes of stocks, which could impact expansion and fundraising efforts.
C-Corporation
C-corporations offer owners the ability to raise an unlimited amount of capital by issuing stock, taking on investors, and public offerings. C Corps have no restrictions on the number or type of shareholders, making them suitable for larger businesses seeking significant investment. A C-corp offers complete separation from personal finances and provides several protections from federal taxes. However, because it provides the owners and shareholders with the greatest asset protection, the corporate structure comes with the heaviest tax and legal responsibilities.
Another notable benefit is the ability to retain earnings within the company without immediate tax consequences. C-Corps can accumulate profits and reinvest them into the business, allowing for growth and development without triggering immediate tax liabilities for shareholders. Additionally, C-Corps can provide various employee benefits, such as healthcare plans and retirement accounts.
C-Corps also offer limited liability protection, shielding shareholders’ personal assets from the company’s debts and legal liabilities. They can also continue to exist independently of changes in ownership, making them a stable and enduring choice for a legal structure for a business.
Drawbacks of C-Corps
However, there are also drawbacks associated with forming a C-Corp. One significant consideration is the potential for double taxation. C-Corps are subject to corporate income tax at the entity level, and any profits distributed to shareholders in the form of dividends are taxed again at the individual level. This can result in a higher overall tax burden compared to pass-through entities like S-Corps or partnerships.
Additionally, C-Corps are also administratively complex, and face greater regulatory scrutiny than other business structures. They must comply with procedures such as holding regular shareholder meetings, maintaining detailed records, and adhering to specific reporting and disclosure obligations.
Choosing the legal structure for a business is an essential task that can seem overwhelming. While there are many legal structures to choose from, it is critical to choose the one that best suits your needs by considering your business type, your funding, and your comfort level with personal liability.
Remember, each type of legal structure has different pros and cons, making more research and understanding of the various factors necessary. Consulting with legal, financial, and tax professionals can help you make an informed decision that aligns with your business objectives while minimizing potential risks.
