How to Determine the Legal Structure of Your Business
Choosing the right legal structure for your business can protect your personal assets if your business is sued. It can also save you money on your taxes and help you attract investors.
Let’s look at some of the possible options for structuring your new company.
Sole Proprietorship & General Partnership
If you’re the only owner of your business, you can operate as a sole proprietorship. If you own the business with other people, it will automatically be a general partnership. You don’t need to file any paperwork to set up a sole proprietorship or general partnership. However, if your business is operating under a name other than your own name (such as ”Joe’s Coffee” or ”Intrepid Designs”) you may need to file documents with your state or locality to establish a fictitious business name, trade name, or dba.
The IRS treats sole proprietorship and general partnerships as ”disregarded entities”. This means the business itself doesn’t pay income taxes. Instead, the owners report their share of business income and expenses on their personal tax returns, and they pay personal income tax on any profits.
If you own a sole proprietorship or general partnership, you’re fully liable for any business debts, even if those debts are a result of something your business partner did. This means a business creditor could go after your personal money, home and other assets as well as the money you have in the business. This liability risk is one of the reasons you might consider forming a corporation or limited liability company, especially if you have business partners.
Corporation or Professional Corporation
You form a corporation by filing paperwork with your state. Once established, a corporation is its own legal entity, separate from its owners. If the corporation can’t pay its debts, creditors can go after corporate bank accounts and assets owned by the company. But they can’t pursue the owners’ personal assets (as long as the owners aren’t accused of any wrongdoing).
In some states, a corporation formed by licensed professionals may be called a ”professional corporation” or a ”professional services corporation” to distinguish it from other types of corporations. Owners of corporations are called shareholders and enjoy several key benefits:
- Owners can be company employees and can participate in company–paid benefit plans, including health insurance and retirement plans. In contrast, owners of sole proprietorship’s and general partnerships are self–employed.
- Shareholder liability for corporate obligations is limited to the shareholders’ investment in the company. Individual shareholders are shielded from personal liability for other shareholders’ or employees’ wrongdoing.
- A corporation may be eligible for flexible tax treatment. By default, corporations are Subchapter C Corporations for federal income tax purposes. A C corporation files its own tax return and pays corporate taxes on its profit. If profits are distributed to the owners, the owners then pay personal income tax on those distributions. To avoid this double taxation, some corporations can elect to be taxed as a Subchapter S corporation. S–Corps aren’t taxed at the corporate level: the corporation’s income passes through to the shareholders’ personal tax returns. The shareholders then pay personal income tax on corporate profit. An S corporation must have 100 or fewer shareholders and meet other requirements.
Corporations have a predictable management structure, and corporate shares are generally easier to transfer than ownership interests in LLCs. Because of this, outside investors tend to prefer investing in corporations.
Limited Liability Company
Like a corporation, a limited liability company, or LLC, limits its owners’ liability for business debts. You establish an LLC by filing documents with your state. LLCs are a popular choice for small businesses because they have the liability protection of a corporation, but with more flexible management, taxation and ownership options and fewer record keeping and reporting requirements.
The owners of an LLC are called ”members,” and an LLC can have one or many members. LLCs can be managed by the members or by a group of managers. If you’re a licensed professional such as an attorney, doctor or architect, your state’s laws may require you to form a Professional Limited Liability Company, or PLLC, instead of an LLC.
By default, a one–member LLC is taxed like a sole proprietorship and a multi–member LLC is taxed like a partnership. Owners who work in the business are considered self–employed and they’ll pay income and self–employment taxes on their share of the company profits. But an LLC can also file a form with the IRS electing to be taxed like a C corporation or an S corporation. The owners of an LLC taxed as an S corporation can be company employees, and this can save money on self–employment taxes.
Limited Partnerships and Limited Liability Partnerships
Limited partnerships and limited liability partnerships also limit liability for some owners. However, they are most commonly used in specific situations or professions.
Alimited partnershipdiffers from a general partnership in that it has general partners and limited partners. A general partner is involved in running the company and must remain fully liable for all company debts. A limited partner can’t be involved in management and liability is limited to the amount invested. Limited partnerships are common in commercial real estate and other industries where it’s desirable to raise money from passive investors.
A limited liability partnership offers limited liability to some or all of the partners, but the specifics vary from one state to another. Some states restrict limited liability partnerships to certain professions. A limited liability partnership could be a good choice if you want limited liability but cannot form an LLC.
Your choice of business structure can affect everything from the amount you’ll pay in taxes to your ability to raise money to your personal exposure if the business fails. Before you make a final decision, discuss your options with an experienced accountant and a business lawyer. In addition to recommending the best legal structure, a lawyer can assist you with business formation and the documents and contracts you’ll need to get started on the right foot.