By: Kristy DeSmit | May 13, 2014
Starting a business can be one of the most terrifying, yet completely rewarding experiences in an entrepreneur’s lifetime.
Whether you are opening a local diner where you can finally put your recipes to use, or have the next time-saving application for working consumers, you will eventually need to ask yourself — what legal structure is the best for my business?
The structure you choose will determine how your business functions, the way it is taxed and the legal liability you will incur as the owner.
Most businesses begin as a sole proprietorship or partnership and evolve into a larger entity, whereby they have to incorporate or change structures into one more suitable to their needs.
To get started, let’s examine the advantages and disadvantages of operating as a sole proprietorship and partnership.
A sole proprietor is an individual who owns and runs a business, referred to as a sole proprietorship. The company is unincorporated at this point. It is often the default starting point for most business owners who are just beginning their business.
As a sole proprietor, you are single-handedly responsible for your company’s debts, mistakes and agreements. This means that if the company goes bankrupt with outstanding debt, you are personally responsible for paying the creditor, investor or family member back the money you owe.
Sole proprietorships don’t change your tax status; you will file a personal income tax return much like you would with a regular employer, but include your profit (company’s income) in your return. Because you are working for yourself, you may be subject to self-employment tax, so be sure to consult with an accountant before filing your annual return in your business’s first fiscal year.
- Simplest legal structure with almost no formation costs or paperwork
- Full control by owner to manage company and make decisions
- Natural starting point for most entrepreneurs. You can easily change structures as your business grows to accommodate earnings or seek greater legal protection.
- Taxed at low personal rates in comparison to high corporate tax rates.
- The business dissolves when the owner dies.
- The owner is liable for all business obligations, including but not limited to, contracts, debts, violations and more. If the sole proprietor fails to repay a loan, a creditor can seize personal possessions to settle the score. It is also quite possible an owner can be sued if debt is not repaid.
- Lower chance of receiving capital because the business may be considered a high risk investment, as there is no equity to impart as collateral.
- No partners
- As previously mentioned, a sole proprietor may be subject to self-employment taxation.
A partnership is one of more individuals working together on a business to generate a profit. In general partnerships, each partner owns equal equity or in accordance to their investment or work contribution. They also incur equal liability in the event of loss or other business obligations.
General partnerships are taxed much the same as sole proprietorships, but they must report their earnings, losses and deductions in an annual information return. Like sole proprietorships, each partner’s equal share of income is taxed at a personal level in their individual income tax return. The income from the partnership itself is not taxed.
If you are in a partnership or are considering a partnership with others, use a partnership agreement to define the responsibilities of each partner as well as outline the distribution of income and losses. A written contract not only prevents disputes between partners, but also ensures everyone is on the same page moving forward.
- Shared responsibilities and liability (depending on the partnership)
- Next to sole proprietorship, this is the simplest form of business structure. It requires very little startup formation costs and little paperwork, with the exception of a partnership contract.
- Double (or triple) the resources, including cash and skills.
- Lower tax rates because partnerships are taxed at personal income level, not the double taxation of a corporation.
- In general partnerships, you are not only liable for your own actions, but also your partner’s actions. If your partner is negligent or makes guarantees your team cannot fulfill, you (and your team) are all personally responsible. Working together and communicating can prevent these types of liability feuds.
- Disagreements may arise from partners “butting heads” when decisions are made collaboratively.
- If a partner withdraws from the agreement, it may dissolve the business depending on the amount of partners involved.
- Partners may be subject to self employment taxes
Above, we discussed the advantages and disadvantages of a general partnership. Other types of partnerships include limited partnerships and joint ventures.
A limited partnership is one in which a partner is only liable for his or her share of the business. For instance, if a limited partner (LP) contributed $10,000 into a company worth $200,000, the partner would only own a 5% stake in the business. Therefore, they would only be responsible for their 5% stake and not accountable for the entire company’s debts. Usually limited partners are investors who do not partake in the daily operations of a business. Day-to-day management is handled by the general partner.
- Limited partner only assumes liability for what they contribute and little to no liability for the rest of the company’s debt or obligations
- These partners don’t have much involvement in day to day operations, freeing them from daily disputes or management woes
- Taxed at a personal level on their investment (pass-through taxation)
- General partner must tend to all daily operations, incur company liability as well as keep limited partner informed.
Joint ventures are a temporary business arrangement in which two or more business partners collaborate on a project or venture to gain mutual benefits by sharing costs, risks, strategy and resources. A joint venture agreement dictates the nature and conditions of their business together. Generally these relationships occur when each business is established and would like access to the tools or resources of one another that they might not have access to on their own. For instance, access to a foreign market.
- Shared resources or risk in order to seek mutual profit. This makes the risk lower and reward higher.
- Individual (pass-through) taxation on profits
- Liable for the actions of their partner(s)
- High potential for conflict when making large business decisions
To summarize, both sole proprietorships and partnerships have a “pass-through” form of taxation in which individuals conduct personal tax returns on the income they receive from the business. Liability is still a personal consideration for both sole proprietors and partnerships, as each structure still leaves individuals responsible for the debts of an organization.
Next, we’ll discuss the various corporate structures, including LLC (Limited Liability Corporation), C Corporation and S Corporation. You will notice the degree of liability change when you incorporate your business, as well as other differentiations discussed in the advantages and disadvantages below.
Limited Liability Company (LLC)
An LLC is a type of legal structure that combines the liability protection of a corporation with the personal tax structure and flexibility of a partnership. In an LLC, the partners are referred to as members.
To form an LLC, an owner must file Articles of Organization with their state, which includes their business name and the name of each member. To further define how an LLC operates, the members should draft an operating agreement, which includes the company’s purpose, member information and contributions, profit and loss distribution, how decisions are made, when meetings are held, accounting methods and more.
Once the articles have been filed and an LLC operating agreement has been signed, the LLC will need to obtain state-specific permits or licenses to operate. Additionally, some states require that you publish the formation of your LLC in a newspaper or filing office. Generally, information regarding these publication specifications can be found at your local newspaper or information center.
- An LLC operates as a separate legal entity so its members are not personally liable for its debts or obligations. Creditors, investors or courts cannot prosecute members individually for business wrongdoings.
- An LLC’s flexible tax structure allows it to be taxed in one of two ways. It can choose pass through taxation in which it is only taxed once at a personal level (members are responsible for filing their earnings on personal income tax returns) or it can be taxed as a corporation, in which case it would be taxed twice — once at a corporate level and again at a personal level.
- Distribution of profits is determined by members and does not have to correspond with ownership.
- Able to seek outside funding — unless the company plans to go public
- Does not have to hold annual meetings or take minutes — a characteristic of a C Corporation.
- Startup paperwork, including filing necessary articles and obtaining licenses.
- Cannot issue stock or shares in exchange for funding
- If the LLC decides to be taxed individually, there are self-employment taxes.
- The LLC may have to dissolve if a certain member withdraws their ownership. However, you can avoid this by specifying continuation in your operating agreement.
A C Corporation, or “C-Corp” for short, is a business that has been incorporated to form its own legal entity.
The partners in a corporation are referred to as shareholders. As its own entity, the C Corp is able to enter agreements, hire employees, borrow money, own assets and pay taxes distinct from its shareholders.
To create a corporation, you must file Articles of Incorporation in the state where your business operates. The articles include information about your business, the share structure, and directors (leaders) of the company.
Similar to an LLC, your corporation will need to obtain the necessary permits and licenses. While it varies by state and business, the corporation would then hold an organizational meeting to develop corporate bylaws to determine its internal management structure and duties, elect directors (if not already done so) and officers, issue stock certificates, and record all necessary documents in a corporate minute book. You may have to attend to additional paperwork, such as filing an initial report, or statement of information to complete the formation process.
There are various kinds of corporations, including private and public. The main difference between a public and private corporation is that shares in public corporations can be bought and sold publicly on the stock exchange. Private corporations don’t issue shares for public trading.
- As a distinct legal entity, forming a corporation deters liability from its shareholders, preventing them from being accountable in the event of financial trouble. However, if the owner makes a personal guarantee to a creditor or investor, they may become personally liable.
- If the C Corp meets certain requirements, it can be taxed as an S Corporation.
- Holds a reputation for being a prestigious entity with a fair amount of credibility
- Investors prefer to invest their money in corporations because there is greater flexibility of ownership in this type of structure.
- Corporations can continue to exist if one shareholder decides to withdraw their portion. However, it’s important to address these situations in a shareholders’ agreement to ensure there are no misunderstandings and devise a plan.
- Unlimited amount of owners
- Different classes of stock for investors, shareholders and employees. Also the transferability of shares.
- Corporate income is taxed twice; once on the corporation’s income (corporate level) and a second time on the shareholder dividends paid out by the corporation (individual shareholder level).
- There tends to be a large amount of paperwork to form a corporation, especially during the initial phases (Articles of Incorporation, Corporate Bylaws, Shareholder’s Agreement etc), but filing online is one way to reduce the amount of papers.
- Initial filing costs — which can also be reduced by filing online.
- In most states, corporations must hold regular shareholder meetings and keep track of minutes during these meetings.
An S Corporation is a taxation treatment for LLCs and C Corporations. It allows for pass-through taxation structure in which individuals (shareholders or members) are only taxed at an individual level. There are specific requirements in order for an LLC or C Corp to be considered an S Corp for tax purposes, including: having no more than 100 shareholders, must operate domestically (within the United States), have no more than one class of stock, and only have allowable shareholders. Other requirements may apply.
- No personal liability — business debts, obligations and mistakes fall back on the corporation and not its shareholders.
- C Corporations can avoid double taxation if they are elected to be taxed as an S Corporation.
- LLCs can raise funds as an S Corp, but still cannot go public.
- C Corps can also raise funds, but they are allowed to go public.
- Can continue to operate as a corporation if one partner decides to dissolve their shares.
- Requires double paperwork — one must set up a C Corporation or LLC and then file to be treated as an S Corp.
- Stricter requirements for a business to be taxed as a S Corp (fewer than 100 shareholders etc.)
- Must hold regular meetings and record minutes
What structure is best for your company?
Now that you’re familiar with the various types of legal structures, you can start to determine which structure is best suited to your business.
- Who is involved in my business currently and will there be others in the future?
- Do I want to remain personally liable or do I prefer the protection of a corporation?
- What type of taxation is preferable? Personal or corporate?
- Do I eventually want to go public?
- How large is my business currently and what structure could it sustain right now?
- If my business were to grow, what structure would best suit my needs?
The needs of your business will change overtime, which is why it is important to ask yourself these questions periodically to deem what is working and what could change, and adjust your structure accordingly. There is no one-size-fits-all approach to choosing a legal structure. It will depend on your situation, and more specifically, your business.
If you are a small business operating locally, you may be content doing so under a partnership. Conversely, if you have a business with plans to expand, it might be worth considering structuring your business as an LLC to limit your liability and achieve flexible tax status.
Whichever you decide, you can always consult other business owners about their experience choosing a business structure or consult with an attorney on the best course of action for your company.
Do you have any experience choosing a business structure? We’d love to hear your story in the comments below!