Choosing the legal structure for your company is one of the most important decisions you will make when starting your business. It will impact how much you pay in taxes, your personal liability, the amount of paperwork and accounting you’re required to do, and your ability to raise money.
This is not a decision to be entered into without seeking expert advice from professionals who can help you determine which entity is best suited to your business. This advice can come from a variety of sources, ranging from the Small Business Association (SBA) to a trusted attorney or accountant.
Here’s a quick look at the most common forms of business entities and a few of the pros and cons associated with each.
Sole Proprietorship
This is the most common structure for small businesses. A sole proprietorship is an unincorporated business owned by a single individual: you. You can have complete managerial control and are entitled to all profits.
Pros
- Easy and inexpensive: A sole proprietorship is the simplest and least expensive business structure to establish. Legal costs are limited to obtaining any necessary license or permits.
- Total control. You are ultimately responsible for the successes (and failures) of your business.
- Basic tax prep. Your business is not taxed as a separate entity, so it’s easy to fulfill the tax reporting requirements. Tax rates are also generally the lowest of the business structures.
Cons
- Unlimited personal liability. Because there is no legal separation between you and your business, you can be held personally liable for the debts, losses, and obligations of the business, as well as liabilities resulting from employee actions.
- Difficult to raise money. Because you can’t sell stock in the business, investors often won’t invest. Banks are also hesitant to lend to a sole proprietorship because of the perceived risk when it comes to repayment.
Partnership
If your new company will be owned and operated by two or more people who agree to share in all aspects of the business, consider structuring it as a partnership.
There are two kinds of partnerships: a general partnership, in which the partners manage the business and assume liability; and a limited partnership, where there are general partners as well as limited partners who serve solely as investors. Unless you have many passive investors, a general partnership is much easier to form.
It’s important to develop a legal partnership agreement that documents how future business decisions will be made, such as how the partners will divide profits, resolve disputes, change ownership, and dissolve the partnership. Although partnership agreements are generally not legally required, it is considered extremely risky to operate without one.
Pros
- Easy and inexpensive. The majority of time spent starting a partnership focuses on developing the partnership agreement.
- Shared financial commitment. Each partner is invested in the success of the business. Partnerships have the advantage of pooling resources to obtain capital, which can be beneficial in terms of securing credit.
- Complementary skills. A good partnership reaps the benefits of the combined strengths, resources, and expertise of its partners.
Cons
- Joint and individual liability. Each partner in a general partnership is personally liable for the financial obligations of the business. They are responsible for their decisions and actions, as well as those made by other partners.
- Disagreements among partners. General partners should consult each other on all decisions, make compromises, and resolve disputes as amicably as possible.
- Shared profits. Each partner shares the profits of their business with the other partners. An unequitable contribution of time, effort, or resources can cause discord among partners. [Partnerships do not have to be equal, require equal contribution, etc.]
Corporation (C Corporation)
A corporation is an independent legal entity, separate from its owners, that requires complying with numerous regulations and tax requirements. The corporate structure is more complex and expensive than most other business structures, and it is generally best suited to companies with multiple employees.
The biggest benefit of corporate status is the liability protection the owner receives. The corporation itself is held legally liable for the actions and debts the business incurs; so if you structure your business as a corporation, you are not putting your personal assets at risk.
Pros
- Limited Liability. Shareholders generally can only be held accountable for their investment in stock of the company, not for business debts, so their personal assets are protected.
- Corporate Tax Treatment. Owners only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends. Any additional profits are taxed at a corporate rate, which is usually lower than a personal income tax rate.
- Attractive to Potential Employees. Corporations are generally able to attract and hire high-quality employees because they offer competitive benefits and the potential for partial ownership through stock options.
Cons
- Time and Money. Corporations are generally more costly and time-consuming ventures to start and operate. Incorporating involves start-up, operating and tax costs that most other structures do not require.
- Additional Paperwork. Corporations are highly regulated by federal, state, and in some cases local agencies, requiring extensive recordkeeping, accounting, and tax preparation.
- Double Taxing. Corporations are taxed at the federal and state levels, and any dividends distributed to shareholders are taxed on their personal returns. One way to avoid double taxation is to structure your business as an S corporation.
S Corporation
S corporations, or S corps, are a more attractive option for small business owners. They still provide owners with the liability protection of a C corporation, and profits and losses can pass through to your personal tax return. Only the shareholders are taxed, not the business itself.
Pros
- Tax savings. Only the wages of the S corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate if at all.
- Business expense tax credits. Some expenses that shareholder/employees incur can be written off as business expenses.
- Separate entity. An S corp is a distinct corporate entity separate from its shareholders. If a shareholder leaves or sells his or her shares, the company can continue doing business relatively undisturbed.
Cons
- Strict operational processes. As a separate structure, an S corp requires scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers, and records maintenance.
- Shareholder compensation requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages.
Limited Liability Company (LLC)
A limited liability company (LLC) is a hybrid that is gaining traction with small business owners. It combines the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.
Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are passed through the business to each member of the LLC. Members report profits and losses on their personal federal tax returns, just like the owners of a partnership. (An LLC with two or more members can choose to be taxed as a corporation or partnership.)
Pros
- Limited liability. Members are protected from personal liability for business decisions or actions of the LLC. However, members are not necessarily shielded from wrongful acts, including those of their employees.
- Shared profits. There are fewer restrictions on profit sharing within an LLC. Members distribute profits as they see fit and determine who has earned what percentage of the profits or losses. [This will be the same as for a corporation or a partnership)
Cons
- Limited life. In many states, when a member leaves an LLC the business is dissolved. The remaining members can decide if they want to start a new LLC or part ways. However, you can include provisions in your operating agreement to prolong the life of the LLC if a member decides to leave.
- Self-employment taxes. LLC members are considered self-employed and must pay tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.
Even after you decide on a business structure, it’s important to reassess your business from time to time. The laws governing these entities and their benefits are subject to change, so make sure you are using the one that best supports your company’s success.
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