Selecting the proper legal structure for your business can enhance your opportunities to succeed, minimize your tax liability, and protect your personal wealth. In this article, we will focus on the six structures most likely to meet the needs of the largest number of entrepreneurs.
By far, the most common legal structure for a small business is a sole proprietorship. Legally, this is considered an extension of the owner. Business profits and losses appear on the owner’s tax return, which eliminates the need for a separate filing. The simplicity of this legal structure is its most attractive attribute.
However, there is a downside. The owner is also personally responsible for all the debts and liabilities of the business. If the business is sued for breach of contract, personal injury, or to collect a debt, the onus falls solely on the owner, who can have his personal property and bank accounts attached by the courts to satisfy the litigants.
At first blush, this may sound the death knell for choosing this option, but one can mitigate these personal risks through the purchase of various insurance products. Often, these products are required by state and local governments to secure a business license anyways.
Limited Liability Company (LLC)
An LLC structure offers a much greater degree of flexibility in terms of tax filing than a sole proprietorship. For example, the LLC allows you the choice of being taxed as an S corporation, a C corporation or as a pass-through, unlike a sole proprietorship, which mandates pass-through tax filings.
Although an individual can form an LLC, another huge advantage of the LLC is that it can have co-owners. These owners are known as members. Ownership percentages are dictated by the Articles of Organization, which, if properly prepared, can make adding members at a later date a relatively easy chore. This is a very important consideration if you want to bring in a partner or partners down the road.
Another advantage of the LLC is that members have the same immunity from liability as a corporation. The LLC structure also allows you to choose a unique name for the business, precluding the necessity of repeating the tiresome task of including doing business as (DBA) on all the paperwork.
On the downside, LLCs are usually subject to a state franchise tax. Check with your local Secretary of State to determine what taxes or fees might apply for an LLC where you live.
Partnership (General & Limited)
In the general partnership (GP) structure, two or more entities are joint owners of the business and share in the profits and losses in accordance with the terms of the partnership agreement. Entities, as referenced previously, may be an individual or individuals, and, also may be a corporation or S-Corporation.
This can be a very advantageous structure for startups. The partnership agreement dictates the breakdown of the profit and loss distribution. Most importantly, this does not need to parallel ownership percentages. However, each partner is liable for the full amount of the GP’s liabilities, regardless of the percentage of the business they have been allocated under the partnership agreement.
Furthermore, the GP itself is not subject to any income or franchise tax, is not subject to any state or federal reporting requirements and creates the GP by means of the partnership agreement rather than a filing with the state. Control of the GP is assumed to be exercised jointly with each party having an equal vote, unless otherwise stated in the partnership agreement. Taxes are paid by each of the joint owners according to its distribution as defined in the partnership agreement. In short, income is pass-through.
In a limited partnership everything largely mirrors the GP, with this exception—a limited partnership (LP) must have a general partner who assumes all the liabilities of the partnership. A further differentiating factor is that all remaining (limited) partners, AKA silent partners, must have no role in the management of the LP. This allows a business to attract outside investors that don’t want to be burdened with a management role, and that have no interest in being exposed to the potential risk represented by the LP’s liabilities or its wrongful acts.
Corporation – C Corporation
Corporations are created by filing Articles of Incorporation with a state’s Secretary of State or other governing body. The corporation is owned by a stockholder or multiple stockholders. Day-to-day operations are carried out by its officers, which are appointed by a board of directors, elected by its stockholder(s).
Stockholders, directors and officers are protected from the liabilities of the company, including their own wrong-doing, except in unusual circumstances. Corporations file their own tax returns and pay their own taxes, state and federal, and bear financial responsibility for franchise fees, if any, and other recurring fees imposed by government.
Stockholders, directors, officers, and employees of the corporation pay taxes on the wages paid to them (if any) by the corporation as ordinary income tax.
An S Corporation can be created after a corporation has been established, as outlined above, for a corporation. It is formed as a result of a stockholder(s) vote for S Corporation status. If the vote carries, the corporation makes a filing through the IRS.
Unlike a C corporation, an S corporation is taxed in the same manner as a partnership, with the profits and losses flowing to the stockholders in proportion to their ownership interest. However, the stockholders retain their protection from liabilities as if they were a C corporation.
The S corporation structure is ideal when the shareholders are employed by the corporation, manage its day-to-day operations, and receive the bulk of the corporation’s income distribution.
What Legal Structure Will You Choose?
We hope this guide has helped you consider which business structure will best suit your needs. Have a question? Feel free to drop a comment below and we’ll try to help!