When starting a business, one critical decision every entrepreneur must make is choosing the most suitable entity structure. The entity structure you choose will not only lay the foundation for legal and operational aspects, but it will also play a significant role in determining your business’s tax implications and liabilities.
What Is a Business Legal Structure?
Before registering your business with the state you’ll be operating in, you’ll need to choose a business structure. A business structure is the formal organization and classification of a business entity, determining how it is legally recognized and operates. This structure defines the relationships between the business and its owners, as well as the level of liability protection, tax implications, and operational flexibility. Common structures include:
- Sole Proprietorships
- S Corporations
- Limited Liability Company (LLC)
When choosing a business structure, it is important to consult with both attorneys and accountants as correcting unfavorable entity structures carries limitations, restrictions, compliance, and tax consequences.
Why Is a Business Legal Structure Important
The business legal structure is a foundational aspect that affects liability, taxation, governance, and overall operations. A well-chosen business legal structure is crucial for several reasons, including providing clarity on ownership, managing liability, and influencing the business's tax treatment.
As you set up your new business, you should be looking beyond the immediate future and considering what is essential for the long-term success and sustainability of the business.
Types of Business Structures
Each type of business structure has distinct characteristics that suit different business needs and goals. Understanding these structures helps entrepreneurs make informed decisions about the legal framework that best aligns with their business objectives and circumstances.
Below, we’ve outlined various types of entity structures, as well as some key considerations for making your decision. This list is non-exhaustive and meant solely as a primer. We always recommend consulting with your tax partner as well as a lawyer before forming a new business entity, as there are both legal and tax effects of this decision an expert will be able to guide you through.
Although the simplicity and ease of setup (and closure) make a sole proprietorship an attractive option for one-person businesses, the personal liability can be a drawback. With a sole proprietorship, the owner is personally responsible for all debts and obligations as a separate business entity is not created. Although you will be able to take a trade name, you will not be able to sell stock.
Sole proprietorship is a safe, low-risk choice for business owners who want to try something out—not for businesses looking to quickly expand and fold in more leadership.
A general partnership is ideal for businesses with two or more owners who want to share decision-making and profits. Much like a sole proprietorship, a general partnership means each partner will be responsible for all of the business’s debts and obligations, and they share liability and risk.
General partnerships are easy to both set up and dissolve, and taxes are simpler to file as you will not have to pay corporate taxes due to the pass-through structure.
A Limited Partnership is a business structure consisting of at least one general partner and one or more limited partners. The general partner assumes unlimited personal liability for the business's debts and obligations, while limited partners enjoy liability protection. This limits their losses to the amount they have personally invested in the partnership. Limited Partnerships are often favored for ventures where investors want to contribute capital without actively participating in the management and decision-making processes.
Limited Liability Partnership
A Limited Liability Partnership is a flexible business structure combining elements of partnerships and corporations. In an LLP, all partners have limited liability, protecting their personal assets from the business's debts and liabilities.
Unlike general partnerships, LLPs allow every partner to actively participate in the management and decision-making processes, making it a popular choice for professional services firms such as law or accounting firms. However, individual partners remain personally responsible for their professional conduct and the consequences of their own errors or omissions.
Limited Liability Company
Unlike a sole proprietorship or a partnership, an LLC provides the benefits of limited liability protection while maintaining flexibility in management and tax treatment. By choosing an LLC, if or when your business faces bankruptcy or lawsuits, your personal assets won’t be at risk. LLCs offer pass-through taxation where profits and losses flow through to individual tax returns.
However, ownership within LLCs can be complicated, with some states requiring a dissolution if a member leaves. In order to prepare for such circumstances, business owners should work with an attorney to create an agreement that includes how ownership transfer, buying, and selling are handled within the entity.
The law regards a corporation as separate from its owners, with legal rights independent of its owners. A corporation can sue and be sued, own and sell property, and sell the rights of its ownership in the form of stocks. Although corporations have extensive rights, they also require more extensive record-keeping, operational processes, and reporting to maintain those rights. The two most common corporation types are:
- C Corporation: A C corporation provides limited liability protection to shareholders and facilitates easier access to capital through stock issuance. However, it is subject to double taxation at the corporate level on profits and at the individual level on dividends.
- S Corporation: An S corporation combines limited liability protection with the pass-through taxation benefits of partnerships and LLCs. Creating an s corporation is subject to specific eligibility criteria, including restrictions on the number and type of shareholders, and requires filing with the IRS in order to gain S corp status.
Although nonprofits are also a type of corporation, there are some distinct differences that separate them from the other types. Nonprofits are legal entities organized and operated for a collective, public, or social benefit.
Because there is less of a focus on profit, nonprofit corporations receive tax exemption, but applying for nonprofit status requires filing with the IRS as a 501(c)(3) corporation. How nonprofit corporations use their funds is also regulated, with things like political campaign spending being banned from acceptable expenses.
What Business Structure Should I Choose?
Looking at the different types of entity structures, it’s easy to see how a new business might fall into two or more of the categories, making it hard to know which entity is the right choice. Careful consideration of the following factors is essential to ensure the chosen structure aligns with the business's objectives and maximizes opportunities for growth and tax efficiency.
10 Factors to Consider When Choosing a Business Structure
When examining liability, you should assess the potential risks and liabilities associated with the business and choose a structure that shields personal assets from business obligations. While a corporation carries the least amount of personal liability since the law holds it is its own entity, entities like sole proprietorships hold the most. Partnerships share the liability between the partners as defined by their partnership agreement.
Evaluate the tax advantages and disadvantages of each structure, considering both current and future tax obligations. An owner of an LLC pays taxes just as a sole proprietor does, with all profit considered as personal income and taxed accordingly at the end of the year, while a corporation files its own tax returns each year, paying taxes on profits after expenses. With your accountant’s guidance, consider factors such as pass-through taxation, self-employment taxes, and potential tax planning opportunities.
Determine the desired ownership and management structure based on the number of owners, their roles, and the decision-making process. If you’re seeking primary control, you should pursue a sole proprietorship or LLC, while corporations are constructed with a board of directors who guides the company’s decision making. Control in a partnership is negotiated.
Assess the different structures and how they offer varying degrees of flexibility in terms of management, decision-making, and distribution of profits. Sole proprietorships and partnerships provide more flexibility, while corporations may have more rigid structures with defined roles and responsibilities.
Each structure comes with its own set of legal and regulatory requirements. Sole proprietorships and partnerships generally have fewer compliance obligations, but they may lack the liability protection of more formal structures. Corporations, on the other hand, often face more stringent compliance requirements due to their legal status. Understanding and adhering to these regulations are crucial for avoiding legal issues and ensuring the business operates within the boundaries of the law.
Assess the potential need for external funding and the preferences of potential investors. If you need to obtain outside funding from an investor, corporations may be more attractive to venture capitalists and investors, who will provide capital in exchange for convertible debt or ownership equity.
Consider the business's growth trajectory and long-term goals, as well as the potential for mergers, acquisitions, or an eventual sale. Certain entity structures may offer more flexibility and tax advantages for future exit strategies.
In addition to legally registering your business entity, you also may need specific licenses and permits to operate. Depending on the type of business you’re forming and its activities, it may need to be licensed at the local, state, and federal levels.
Ownership transferability is a key consideration for those looking to establish a business that may undergo changes in ownership over time. Sole proprietorships and partnerships may face challenges in transferring ownership, as it often involves reorganizing the entire business. Corporations, particularly those with publicly traded shares, offer greater ease in transferring ownership through buying and selling shares in the stock market. Considering the long-term goals and potential changes in ownership can guide the selection of a business structure that aligns with the desired level of transferability.
Costs are a practical and financial aspect that entrepreneurs must carefully evaluate when choosing a business structure. The costs associated with formation, maintenance, and compliance vary significantly between structures. Sole proprietorships and partnerships are generally more cost-effective to establish and maintain, with fewer administrative requirements. Corporations may involve higher initial costs and ongoing fees, but they often provide greater access to capital and potential tax advantages. Balancing the upfront and ongoing expenses against the benefits each structure offers is crucial for making a financially sound decision.
Contact Mowery & Schoenfeld for Help Choosing the Right Legal Structure for Your Business
Deciding on the most appropriate entity structure is a complex task that requires careful analysis and understanding of legal, operational, and tax implications. This is a complicated process which requires professional insight. Before selecting an entity, schedule a meeting with Mowery & Schoenfeld today to help you navigate choosing a legal structure that’s tax effective for your situation.