Business Startups: Choosing A Legal Business Structure

By on June 1, 2018
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So, you’ve decided to start a business. You’re probably eager to jump right in and start selling your products or services, but there’s some important legwork to do before you get started. The first order of business is deciding what legal business structure best fits your situation. This is not a decision to be taken lightly, however. The business structure you choose will have legal and tax implications, so you want to make an educated decision. Be sure you thoroughly understand the different types of legal business structures available to you and what factors you should consider when making this important decision.

Legal Business Structures

Different business structures have different tax and legal implications. Below is a general overview of each type.

Sole Proprietorship – Sole proprietorships are inexpensive to create. Owners report profits and losses on their personal tax returns and are liable for all business actions and debts.

General Partnership – General partnerships are also inexpensive to create. Owners report profits and losses on their personal tax returns and are personally liable for all business actions and debts.

Limited Liability Company (LLC) – LLCs are more costly to create, but offer more flexibility. Owners can choose to be taxed as a partnership or a corporation. Profits and losses can be allocated differently than ownership interests. Owners benefit from limited personal liability for business debts.

Regular “R” Corporation – Regular corporations are costly to create and require a lot of paperwork. They operate as a separate taxable entity. Owners benefit from limited personal liability for business debts. Unlike other structures, corporations can write off fringe benefits—extra benefits supplementing an employee’s salary, e.g., health insurance.

“S” Corporation – “S” corporations, like regular corporations, are also costly. They are similar in structure to an LLC, but income must be allocated according to the amount of ownership interest in the company. Owners report profits and losses on their personal tax returns but can use corporate loss to offset income. Owners benefit from personal liability for business debts.

Non-profit Corporation – Non-profit corporation status is only available to groups organized for charity, education, or religious purposes. Organizers do not pay income taxes. Assets given to a non-profit must remain with the organization or be transferred to another non-profit if the organization terminates. Charitable contributions are tax deductible.

Limited Liability Partnership (LLP) – LLPs are not available in all states and are sometimes limited to certain professions. Owners report profits and losses on their personal tax returns. Each partner’s personal liability is based on their contribution to the business and they often remain liable for business actions and debt.

FSN recently published a series of articles on Business Startups. For more in-depth information, read our articles on Limited Liability Companies, Limited Liability Partnerships, and Corporations.

Choosing Your Structure

Which legal business structure is best for you? Well, there are a several factors to consider; size, location, risks and liabilities, tax requirements, and investment needs.

Size

What is the size of your business? Are you in business alone or do you have partners? The number of owners and employees will help you narrow down the structures that fit your business. For example, if you are starting a business by yourself, a sole proprietorship or an LLC may be viable options. However, if you have one or more partners, you might look at the various partnership structures. If your company is large with multiple owners and employees, some form of a corporation may be best.

Location

Where do you plan to do business? State requirements vary and not all business structures are available in every state. Some structures even have eligibility requirements based on location. For example, only domestic businesses can elect “S” corporation status. Seek the help of a qualified business attorney to ensure you understand the business requirements for your state.

Risks & Liabilities

Do you need personal liability protection? This is one of the most important questions to ask yourself when you are considering a business structure. The difference between being a sole proprietor and forming a legal business entity is that as a sole proprietor you are personally liable for your business debts. Legal structures offer limited liability protection for your personal assets. The key word is “limited”; it does not cover absolutely everything. For example, if you directly cause harm to another person, you are liable for your actions. If a person slips and falls on your premises, you are liable. Forming a legal structure can be cost prohibitive for some businesses, especially small businesses and startups. You have to weigh the cost of forming a legal entity against the risks.

The best ownership structure for your business depends on the type of services or products you provide. If your business engages in “risky” activities, i.e., stock trading or roofing,  definitely consider forming a legal business entity that provides personal liability protection. A corporation or an LLC are good options to explore. You may also want to consider incorporating if you are an independent contractor. Independent contractors are often at risk of getting reclassified as employees. If you run a web storefront from your home office, a sole proprietorship may be appropriate. In this case, depending on the products and/or services you sell, you may still want to purchase liability insurance.

Tax Requirements

What are your tax requirements? Do you want to file your profits and losses on your personal tax returns or keep your business filings separate?

Sole proprietorships, partnerships, and LLCs are considered “pass-through” tax entities, which means that all of the profits and losses pass through the business to the owners who report profits and losses on their personal income tax returns. Owners must report and pay taxes on all profits of the business, even if they money is kept in the business account to cover expenses.

In contrast, a corporation operates as a separate taxable entity. The owners do not report profits and only pay taxes on money they receive in the form of salaries, bonuses, and dividends. The corporation itself pays taxes on retained earnings—profits that are left in the company from year to year. Sometimes corporations end up with a lower combined tax bill than unincorporated businesses because they do not have to pay income tax and are taxed at a lower rate.

Investment Needs

Do you need investment capital? Corporations allow owners to sell shares of the company through stock offerings. Offering stock makes it easier to attract investors and to hire and retain key employees. If you do not have a need to attract investors and you do not foresee your business ever “going public”, forming a corporation probably isn’t worth the cost.

Can I Change My Mind?

While choosing your legal business structure is a big decision, it is not set in stone. You can change your mind as your business grows and your business needs change. Here is a list of considerations to keep in mind. If you answer yes to any of these questions, you may want to revisit your options.

  • Has your business started to turn a profit?
  • Have your products and/or services changed?
  • Have your business risks increased or decreased? Will regular business insurance cover these risks?
  • Have your personal assets increased since you started your business?
  • Do you have a need for investment capital?
  • Do you need to hire employees?
  • Do you need to provide benefits to your employees?

Ideally, you want choose your business structure before you register your business name. You are typically required to include the entity type in the name, e.g., “Inc.” or “LLP”. Be sure to do your homework before making a decision. Consult with a business attorney in your state to ensure you understand the requirements and implications of forming a legal business entity.

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About Harold Goldman

I am the founder of FinancialSafetyNet.org, and a Retirement Planning and Long-Term Care specialist. I am also the President of Emes Insurance Services, Inc., a Murrieta based insurance agency designed to help people with Retirement Planning and funding for College. I believe in educating my clients to become financially competent in an effort to develop plans for guaranteed income, protection against loss and tax-advantaged growth. To contact me Call (844)-376-2265

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