Updated: May 5
One of the most important decision to make when starting a business is deciding the type of legal structure that makes the most sense for your company. The most popular ways to structure a company include a sole proprietorship, partnership, corporation, and limited liability company.
There are many variables to take into consideration when deciding how to structure your business entity. Ultimately, the importance of the decision comes down to the ability to protect your personal assets, your total tax obligation, and the amount of documentation legally required for your business.
If you find yourself asking “What legal structure makes sense for my business?” then look no further. This article breaks down the various options and their strengths and weaknesses.
The Sole Proprietorship
A sole proprietorship is considered to be the most common type of business organization, and is designed for businesses with only one owner. In this case, there is no legal distinction between the business and the owner.
Compared to other business entities, a sole proprietorship is the easiest to form. It also offers complete managerial control to the owner. A caveat of this legal structure is that all financial obligations of the business will be the owner’s personal liability. If the business fails to meet certain obligations, the owner will have to tap into their own personal finances to make up for it.
A partnership is owned by two or more people who agreed to share the profits or losses of the business entity. It’s almost identical to a sole proprietorship. Each partner can contribute capital, labor, and skills in exchange for ownership of the business. It’s just as easy to form as a sole proprietorship, but the weakness of this business entity lies in the potential problems between partners. If there are major disagreements in how to run the business, a legal battle may ensue, and a dissolution of the legal entity may occur as a result.
If you’re planning to form a partnership, consider creating a detailed partnership agreement to minimize disagreement factors while running the business.
A corporation is the entity created to conduct business, and acts as a completely separate entity from the founder/owners of the organization. Because of it’s distinction, a corporation can be taxed and can be held liable for any related actions within the organization while running the business.
Unlike a sole proprietorship or partnership, a corporation cannot hold its owner liable for financial obligations, because it is considered as a separate entity.
One of the major disadvantages of forming a corporation is the cost to form the entity, especially when compared to a sole proprietorship or partnership. Another major disadvantage is the large amount of record keeping required to be compliant with legal regulations. Finally, the level of taxation ultimately depends on the amount of money a corporation takes in.
A further complication when deciding whether or not to incorporate is that there are multiple types of corporations to consider. If you’re planning to publicly trade stock, a C Corporation is the best option and makes the most sense for bigger companies. The owners are called “shareholders,” which are separated from the actual corporation as a distinct legal entity. C corporations are subject to double taxation, which means that income taxes are paid twice on the same source of earned income. Profits are taxed at corporate level, then the distributions of profits (dividends) will be taxed once again at individual level.
Shareholders have limited liability protection, but they can lose their limited liability status if complex formalities are not followed. This can hold them personally liable for any debts and obligations of the corporation.
For the smaller businesses, an S Corporation is a type of legal entity allows owners to avoid double taxation. Corporation with more than 100 shareholders that are not natural people are not eligible to incorporate as an S corporation. Also, like C corporations, shareholders can also lose their limited liability status if complex formalities are not followed.
The Limited Liability Company
When deciding “What legal structure makes sense for my business?” you might land on the limited liability company distinction.
A Limited Liability Company (LLC) has the liability protection of a corporation, and the tax benefits of sole proprietorship and partnership. It’s considered to be a hybrid form of the aforementioned business entities. It has recently gaining popularity because of the practicality and flexibility it offers.
An LLC offers limited liability protection, and there are certain tax benefits associated with forming an LLC. However, depending on local law, the limited liability protection can be revoked. This might happen if an owner departs from the entity, or dies.
With so many options to choose from, it’s important to weigh the strengths and weaknesses of each legal business structure. Answer the question of “What legal structure makes sense for my business?” by carefully reviewing the options outlined in this article.
Knowing that choosing the wrong legal structure for your business can cause a lot of problems, it might make sense to consult with a professional. Contact the professionals at VMG Group for a free consultation!