Choosing A Legal Structure For Your Business

This is where my business blog may actually start to be useful to some of you.

Needless to say, choosing your business’ legal structure is one of the first, and most important, things you need to do throughout the business planning process. While it may seem like a daunting task to figure out which direction you should go, it is something that you need to figure out early in the process so you can begin to plan accordingly. In fact, this decision is so important that it may be worth it to consult an attorney or an accountant to help you with the decision.

Anyway, there are several different legal entities you can choose for your business; a sole proprietorship, partnership, a corporation (C-Corp or S-Corp) or a Limited Liability Company (LLC). Here is a great resource from the Small Business Administration that goes over the highlights of each of these different entities. In addition to this great resource, I’ll go ahead and give you the quick and dirty on each one, as well as tell you why my business partner and I decided to go with an LLC for our business.

The first type of business entity is a sole proprietorship. Sole proprietorships are a very common legal entity for small businesses because they are relatively easy and inexpensive to establish, are owned by one person and that one person is typically in control of all of the day to day operations of the business. The sole proprietor receives all of the income (and losses) for the business, and all of the profits are taxed at the sole proprietor’s tax rate. Unfortunately, this type of entity has a very large downside: the sole proprietor has unlimited liability and assumes all of the business’ debts. Both the assets of the business and of the sole proprietor (i.e. their home, personal bank account, etc.) are at risk in a sole proprietorship.

The second type of business entity is a partnership, in which two or more people split ownership of a business. Much like a sole proprietorship, partnerships are relatively cheap and easy to establish, however you may need to consult a lawyer to help draft a partnership agreement. Again, all of the businesses profits are taxed as income for each of the partners, so their individual tax rate will determine the amount of taxes paid. Additionally, since there are more people involved, the liability for the business is spread among at least two people. That being said, the large downside to partnerships is there is still unlimited liability, even though it is spread among the partners, and a partner’s personal assets are still at risk. Also, partnerships may not last forever, as it is possible they can be dissolved in the event of a partner’s withdrawal or death.

The third type of business entity is a standard corporation or a C-Corp. In the eyes of the law, a corporation is its own stand alone entity, meaning two key things: First, it limits the liability of each of its shareholders (owners) and second, it is “double taxed” meaning it is taxed at the corporate level and then the owners are taxed on what they take from the business (more often than not, in the form of a salary). If you chose the route of becoming a corporation, expect a fair amount of time, money and paperwork to get everything set up, but if you choose a field where you risk being sued, that extra protection may be worth it.

The fourth type of business entity is another form of a corporation, but it is called an S-Corp. In an S-Corp the shareholders (owners) of the business are afforded the same protection as a C-Corp, however they have the option to allow the earnings and profits of the business to be taxed at their individual rate, thus avoiding double taxation. However, if the shareholder works for the company, they must pay themselves a fair and reasonable salary for the work they are performing, assuming there is a profit. If the shareholder does not do this, they run the risk of having all of the business’ earnings be reclassified and subject to payroll taxes.

The fifth type of business entity, and the one that my business partner and I ultimately chose, is a Limited Liability Company or an LLC. This relatively new business entity is set up to provide the limited liability of a corporation with the tax structure of a partnership, thus giving you the best of both worlds. While it takes more time, money and paperwork to set up than a general partnership, I believe the extra effort is worth it. An LLC is good to have when you are going to have few investors and the members of the LLC are active in the day to day operations of the business. Here’s a good webpage that goes into more detail regarding an LLC.

We ultimately narrowed our choices down to an S-Corp or an LLC. We ultimately decided to go with the LLC because we wanted the protection of limited liability, the tax structure of a partnership (which both pretty much provide) and we wanted something that was flexible and would be easy to set up and maintain. In an S-Corp, you have to file articles of incorporation with the state, form a board of directors, have an annual shareholders meeting and keep minutes. In general, it seemed a bit more rigid than an LLC and just seemed to be more of a hassle.

Again, as I stated earlier, if you are going to make this decision for your business, make sure that you put a lot of thought into this and, at the very least, consider using the services of a lawyer or an accountant. Hopefully this will give you a good start, but make sure you do plenty of your own research and due diligence.

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