If you are starting a business, one of the first decisions to make is the legal structure of the business. This decision will impact your taxes, liability, and control over the business. You will want to take into consideration the following:
- How large do you expect the business to be?
- What level of personal liability are you comfortable with?
- Do you anticipate much liability in the daily operations of the business?
- How much revenue do you project?
- How comfortable are you with strict organizational structures?
- How do the owner(s) plan to take profits out of the business?
This decision should not be taken lightly. Consult your accountant and attorney for advice before making a final decision. They can help guide you through the implications of how you organize your business. They are also the experts in any relevant state and federal laws.
There are three major categories of legal business structures with variations on each. Here are some of the most common legal structures with the pros and cons of each.
Most small businesses start out as a sole proprietorship. This is when there is only one owner who is also responsible for the day-to-day operations of the business. The owner controls all the assets of the business and takes on all the liability of the business operations. Profits and losses are reported directly on the owner’s personal income taxes. In effect, the business and the owner are the same entity legally.
Advantages of Sole Proprietorship
- Easiest form of business to set up and dissolve.
- Single owner has complete control over the business.
- All profits can be re-invested in the business or can be used by the owner.
Disadvantages of Sole Proprietorship
- Owner has full liability for business operations. This includes all debts or lawsuits against the business. The owner’s personal assets are at risk.
- It is harder to raise capital from commercial sources with a management team of one.
- Employee benefits can not be deducted from the business income. This includes the owner’s health insurance.
Variation of Sole Proprietorship
- There is only one type of sole proprietorship.
Partnerships are similar to a sole proprietorship except that this entity includes two or more people who share ownership of the business. The day-to-day management of the business may or may not be divided among the partners. Once again the law looks on the owners and the business as a single entity. An operating agreement should be drawn up by a lawyer and signed by all partners governing how the ownership is divided, profits will be distributed, new partners added, and the business dissolved. The cost for a lawyer to write up a good operating agreement is far less than the litigation that may arise over the life of a business.
Advantages of Partnerships
- They are still easy to establish, but you should have a professionally written operating agreement.
- Liability is spread over several owners.
- All profits can be re-invested or flow directly to the owners.
- It is easier to get capital from traditional sources including banks.
Disadvantages of Partnerships
- All the partners are liable for the debt and lawsuits of the business. The partners’ personal assets are at risk.
- Profits and decision-making is shared if conflict arises.
- Employee benefits can not be deducted from the business income. This includes health insurance.
Variations of Partnerships
- General Partners — Members of the ownership team are responsible for day-to-day management, associated liability, and share of profits. Sometimes they are called active partners.
- Limited Partners (LLP) — Members of the ownership team only have liability up to their investment and generally have limited input into the day-to-day operations of the business. Sometimes they are called silent partners.
A corporation is registered with the state where the company resides. Legally it is a unique entity from the owners. The taxes are paid by the corporation and it can be sued or enter into contractual agreements. A corporation is owned by shareholders who elect a board of directors to manage the day-to-day business decisions. A lawyer should draw up the ownership agreements.
Advantages of Corporations
- Shareholders have limited liability for the corporation’s debts and liabilities.
- Shareholders can only be held accountable for their investment in the stock of the business.
- Easier to raise capital through the sale of stock or through commercial means.
- Employee benefits can be deducted from the corporation’s profits for taxes.
Disadvantages of Corporations
- More difficult to form than a partnership, however most states now have online options that eliminate the paperwork.
- Additional regulations and reporting are required from federal, state and local governments.
- Owners’ income may be subject to double taxation.
Variations of Corporations
- S Corporations — An S Corporation is only a tax election. It enables the shareholders to treat the earnings and profits as distributions and have them pass through directly to the owners personal income taxes, however the owners’ pay must be comparable to what any employee would be paid to do a similar job at another company. The IRS can reclassify the business and the shareholders will be liable for all payroll taxes if all requirements are not met.
- Limited Liability Company (LLC) — An LLC was designed to provide many of the benefits of both partnerships and corporations. There is limited liability to the owners like a corporation, but the flow of profit works like a partnership. The income of the business is reported on the shareholders personal income taxes as income.