What Legal Structure Is Best for Your Business?
One of the first decisions you’ll need to make when you start a business is to determine the correct legal structure for your company. But how do you decide which legal structure is right for your business?
You will need professional legal guidance to make this decision, but the first step is learning what the different structures are, depending on your situation, your long-term goals, and your preferences.
4 Types of Legal Structures for Business:
We’ve outlined the four most common business legal structures with considerations for each below, including tax, liability, and formation of each. Ready?
1. Sole Proprietorship
A type of business entity that is owned and run by one individual – there is no legal distinction between the owner and the business. Sole Proprietorships are the most common form of legal structure for small businesses.
Taxation: A sole Proprietorship has pass-through taxation. The business itself does not file a tax return. Instead, the income (or loss) passes through and is reported on the owner’s personal tax return through a Schedule C (Form 1040).
Liability: The Owner of the sole proprietorship has unlimited personal liability for any liabilities incurred by the business. You can mitigate this risk with insurance and sound contracts.
Formation: The sole proprietorship is the simplest way of doing business. The costs to create a sole proprietorship are very low and very little formality is required.
Pros of a Sole Proprietorship:
• Easy and fairly cheap to establish.
• Owner has absolute control over the business.
Cons of a Sole Proprietorship:
• Owner has unlimited personal exposure to risk, as the owner is responsible for all liabilities incurred by the business.
• Investors typically would not invest in a business organized as a sole proprietorship.
2. General Partnership
An association between two or more people in business seeking a profit. Partnerships can be created with little formality, but because more than one person is involved, a partnership agreement should be created. A partnership agreement stipulates the terms of the partnership by formalizing rules for profit/loss sharing, ownership percentages, dissolution terms, and management rights among many other things.
Taxation: A partnership is a tax-reporting entity, not a tax paying entity. A partnership must file an annual information return (Form 1065) with the IRS to report income and losses from operations, but it does not pay federal income tax. Profits and Losses are passed through to the owners based on their profit sharing percentages outlined in the Partnership Agreement. Each partner pays taxes on their share of the profit/loss.
Liability: Owners typically have unlimited personal liability. Each partner is jointly liable for the partnerships obligations.
Formation: Usually easy to create, but it is important to have a partnership agreement created by an experienced attorney. Partnership agreements establish the terms of the partnership and typically cover topics such as:
• Capital Contributions
• Distributions of profits/losses
• Management Responsibilities
Pros of General Partnerships:
• Fairly easy to create and maintain.
• Profits and losses are passed through to the owner’s personal tax returns.
Cons of General Partnerships:
• Partners are personally liable for business debt and liabilities.
• Can lead to management and oversight issues absent a partnership agreement.
3. Limited Liability Company (LLC)
A hybrid between a corporation, general partnership, and sole proprietorship. Owners of an LLC are called members. Members may include individuals, corporations, other LLCs and foreign entities. Most states permit an LLC with only one owner, called a “single member LLC.”
Taxation: An LLC is considered a “pass through entity” for tax purposes. This means, business income passes through the business to LLC members who report their share of profits or losses on their individual income tax returns. The LLC entity is only required to file an informational tax return, similar in character to the general partnership. Single member LLCs are allowed to report business expenses on Form 1040 Schedule C, E, or F. LLCs with more than one member usually file a partnership return Form 1065.
Liability: LLC members are protected from personal liability for business debts and claims, a feature known as “limited liability.” If a business with limited liability owes money or faces a lawsuit, only the assets of the business itself are at risk. Creditors can’t reach personal assets of the LLC members, except in cases of fraud or illegality. LLC members should exercise caution so that they don’t “pierce the corporate veil,” which would expose members to personal liability. For example, LLC owners should not use a personal checking account for business purposes, and should always use the LLC business name (rather than owner’s individual names) when working with customers.
Formation: To form an LLC, you must pay a filing fee ($100-$800) and must have articles of organization when at the time the entity is established. Operating agreements are highly recommended, but not required by all states. Much like a partnership agreement or corporate bylaws, the LLC operating agreement sets out rules for ownership and operation of business. A standard operating agreement includes:
• Ownership interest for each member
• Member rights and responsibilities
• Member voting power
• Profit & Loss allocation
• Management Structure
• Buy-Sell provision
Pros of LLC Structure:
• Owners have limited liability, meaning that the entity is responsible for all liabilities incurred by the company.
• Profits and losses of company are passed on to the member and are only taxed at the individual level.
• Allows an unlimited number of members
Cons of LLC Structure:
• Often subject to additional taxes at the state level.
• Each member’s share of profit represents taxable income, even if the profit wasn’t distributed.
4. Corporations (C-Corp and S-Corp)
Corporations are the most complex business structure. A corporation is a legal entity that is separate and independent from the people who own or run the corporation, namely shareholders. A corporation has the ability to enter into contracts separate from that of the shareholders, but it also has certain responsibilities such as the payment of taxes. Corporations are generally more appropriate for larger established companies with multiple employees or when other factors apply (i.e. corporation sells a product or provides a service that could expose the business to sizable liability). Ownership is designated by issuing shares of stock.
The two types of corporations are C-Corps and S-Corps. The major difference among the two types of corporations is the tax treatment of the two entities:
Taxation (C-Corp): For federal income tax purposes, a C-Corp is recognized as a separate taxpaying entity, thus the entity files its own tax return (Form 1120). A c-corporation is subject to corporate income tax on any corporate profits (entity pays taxes). Shareholders pay personal income tax on the corporate profits distributed by the corporation to the owners. As a result, C-corps are subject to “double taxation.”
Taxation (S-corp): S-Corps elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. However, the entity is required to report income, losses, gains, deductions, credit, etc. on Form 1120S. Shareholders of S corporations report the corporation’s income and losses on their personal tax returns pay federal income tax at their individual tax rates. Thus, S- Corps avoid double taxation.
Liability: A corporation is a legal entity that is “immortal,” meaning it does not terminate upon the shareholders death. Corporation shareholders have limited liability as they are not personally liable for debts and obligations incurred by the company. Shareholders cannot lose more money than the amount they invested in the corporation. Similar to the provisions of an LLC, shareholders should be careful not to “pierce the corporate veil.” Personal checking accounts should not be used for business purposes, and the corporate name should always be used when interacting with customers.
Formation: Corporations are more complex entities to create, have more legal and accounting requirements and are more complex to operate than sole proprietorships, partnerships, or LLCs. One of the major disadvantages of a corporation is the high level of governance and oversight by the board of directors. Often times, this prolongs the decision making when multiple shareholders or investors are involved.
Pros of Corporations:
• Corporate shareholders have limited liability, meaning the entity is responsible for all liabilities incurred by the company.
• Usually a favorable formation for investors.
Cons of Corporations:
• The process to establish the business is more rigorous and costly.
• Earnings are subject to “double taxation”, meaning that earnings are taxed at the entity level and the individual level upon distribution to shareholders.
• High level of governance and oversight by the board of directors.
Want more info on which business structure might work best for your business?
Here are two additional resources:
- NOTE: Determining the legal structure for your business is an incredibly important decision that requires professional legal guidance. The information and reference materials contained here are intended solely for the general information of the reader. It is not intended to take the place of professional legal guidance.
Want to know the other steps for starting a business? Check out our blog post “11 Steps to Start a Business in Tennessee or Alabama.”
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