One of the most important decisions you’ll make as the owner of a new business is selecting the right legal structure for your enterprise. The setup can have a crucial impact on the way the business gets taxed, the amount of paperwork required, and the level of personal liability you’ll face.
There are a number of options for a business structure, with pros and cons worth careful consideration depending on business goals, including whether it plans to raise capital. It is highly recommended that you seek legal or accounting guidance in this process of deciding on and establishing the structure of your business.
We discuss the most common business structure options below:
This is the simplest structure for a business starting out. It means a business is owned and run by one individual, with no distinction between that individual and the business. The owner is entitled to all assets and profits and responsible for all liabilities and losses.
As for tax liability, the company’s income is considered the owner’s income. As such, the company’s profits and losses are included on the business owner’s personal income tax return, and the business itself is not taxed separately.
Advantages of a sole proprietorship include the fact that it’s the simplest and least expensive structure to set up. The owner also retains complete control of all business decisions. However, with greater control comes greater burden. The business owner alone is ultimately responsible for the success of the company and assumes personal liability for all debts and obligations of the business, as there is no legal separation between the owner and the business. Raising money also could be relatively difficult for a sole proprietor, as banks and other lenders use the owner’s personal credit profile to determine qualification for business loans.
If you plan on having two or more individuals in charge of the business, a partnership structure may be suitable. There are two types of partnerships: general and limited.
In a general partnership, the partners own and manage the company, with equal control unless otherwise specified in an agreement. The partners have the ability and legal authority to actively manage the business. They also have unlimited liability for the business’ debts and obligations.
A limited partnership involves both general and limited partners. The general partners, as just mentioned, own and operate the business, assuming liability for the partnership. Limited partners, on the other hand, serve as investors only; they contribute financially to the company and receive a share of the profits in exchange. But they have limited control and responsibilities regarding the daily operations of the company, and they aren’t personally subject to the company’s liabilities. Limited partners are liable to the extent of their investment in the limited partnership.
A partnership does not pay income taxes but “passes through” any of its profits or losses to its partners. The individual partners are to include their share of the business’ income or loss on their personal tax returns. General partners also pay self-employment taxes, while limited partners do not.
Limited Liability Company
A limited liability company (LLC) is a hybrid structure, bringing together the benefits of corporations and partnerships.
An LLC is similar to a corporation in that it provides business owners limited liability protection. One difference is that an LLC has fewer and less formal requirements for its operation than a corporation.
Compared to a partnership, an LLC similarly allows for pass-through tax treatment, meaning the company’s profits are not subject to corporate taxes but are included in the members’ personal tax returns. A difference from a partnership is that an LLC offers liability protection to all members of the company, whereas a partnership only provides such protection to limited partners and not general partners.
Setting up an LLC involves filing articles of organization with the secretary of state. This structure typically has a limited life, with some states stipulating the company be dissolved after 30 years.
A corporation is a legal entity that is separate from its owners. Profits, losses and taxes all apply at the corporate level. Corporations offer business owners the strongest protection against personal liability. At the same time, it is more costly to form than other structures and comes with more extensive reporting and record-keeping requirements.
Relative to sole proprietorships and partnerships, corporations allow a broader range of financing options. They can issue stock, whether to a small number of shareholders or via public offerings to a larger investor base. Loans or lines of credit are approved based on the corporate credit history rather than the owners’ personal track record. Corporations can also seek funding through venture capital or angel investors.
The two common designations for a corporation are C Corp and S Corp. Key distinctions between the two include the following:
- Within a C Corp framework, income is taxed twice – first at the corporate level, and again at the personal level when shareholders are paid dividends. An S Corp, on the other hand, is designed to avoid double taxation. It allows profits and losses to be passed through to the owners’ personal income, bypassing corporate taxes.
- As for corporate ownership, a C Corp does not have a limit on how many shareholders it can have. An S Corp typically is restricted to 100 shareholders, and all shareholders must be U.S. citizens or residents.
- Shareholders must be individuals, estates or trusts
We’ve covered the basics of some of the most commonly used business structures, but this list is by no means exhaustive. The determination of which structure to set up will ultimately depend on the unique circumstances, needs, and objectives of the business and the owners. Some structures are more multifaceted and challenging to set up than others, and some of the different elements can be combined. Legal structures can also be changed during the life of the business. Given the complexity involved in establishing a business structure, business owners would benefit from consulting with legal and financial specialists in this imperative process.