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| Business Structure Basics |
One of the first things you have to do when starting a business is to determine the legal structure for your business. This is often a very confusing act that leaves a lot of business owners frustrated.
The most critical factors you should consider when evaluating your options are legal liability and taxes. Legal liability is a determination of the most ideal form of protection from common business liabilities that could potentially threaten your business’s assets as well as your personal assets. You and your partners should consult your attorney to determine what your liabilities can be.
From a tax perspective you want to determine what legal structure will allow you to take advantage of the many tax breaks available. Taxes are always a big area of concern for business owners, so being able to legally reduce your tax requirements can be critical to the success of your business. You as a business owner work very hard to generate sales for your
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business and it’s painful to have to unnecessarily hand over a significant portion of hard-earned revenue in the form of taxes. Even as a small business owner you a significant number of tax breaks available to you and the legal form you choose affects the types of breaks available.
So what are the different business types, and how do taxes differ across them?
When considering which legal entity to choose you will have your choice of the following options:
| Sole Proprietorship |
| General partnership |
| Limited Partnership |
| Corporatioin |
| Limited Liability Company |
Sole Proprietorship
The fastest and least difficult legal entity to establish is the sole proprietorship. Generally, this legal structure has few setup requirements and is very cost effective. Some of the procedures that are typically required for a sole proprietorship are:
| Occupancy permit for your business location |
| Business license |
| Franchise/Registration number (for tax purposes) |
An attractive feature of sole proprietorships is that most setup requirements are simple and can be completed without soliciting the support of an attorney. A clear distinction of a sole proprietorship is that you are the only owner and have complete control over all of the business’s operating activities.
General Partnership
General partnerships, similar to sole proprietorships, are one of the easier legal structures to setup. They too are relatively cost effective and are limited in setup requirements. One of the key differences, however, is the need to craft a comprehensive partnership agreement between all partners involved. Some things that should be included in the partnership agreement are:
| Start up capital expected from each partner |
| Partner rights and duties |
| Profits and losses sharing |
| Cash withdrawals and salaries |
| Dispute resolution and new partner intake |
| Company dissolution
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Limited Partnership
Limited partnerships are very similar to general partnership in natured. The most critical difference is that the partners in limited partnerships are protected legally. Each partner’s liability does not extend any further than the amount of their initial investment. This legal entity allows passive investors to take advantage of the profits of the company while limiting their exposure to losses. As long as the limited partner is inactive they are eligible for this protection.
Corporation
Corporations differ from the partnerships in that they in effect create a legal entity that exists apart from those people who formed it. Forming a corporation only requires one individual to complete an application in the state they wish to incorporate in. Some of the key information that the incorporator will provide during the process is:
| Reason for establishing the corporation |
| Names and addresses of the incorporators |
| Amount and types of capital stock the corporation will be authorized to issue |
| Rights and privileges of the holders of each class of stock |
There are a few common reasons that make operating as a corporation more difficult than partnerships. First, you will have the added responsibility of keeping records and other administrative details. In addition, corporations come with an added tax burden.
On the brighter side, corporations provide protection for the shareholders by separating liabilities generated by the organization from the shareholders. The reason for this is that the corporation is viewed as a separate entity separately from those individuals who manage it. Three additional reasons for utilizing corporations as your legal structure are indefinite life, transferability of shares, and the ability raise investment capital.
The life of a corporation does end until it completes the objective it establishes upon inception, is acquired/merges with another company, or unless it goes bankrupt.
Another benefit of the corporation legal structure is the ability to transfer ownership in a relatively easy manner. Under other legal structures it can be burdensome to transfer ownership to another individual. However, with corporations, shares actually represent all of the shareholder’s rights. Typically it simply requires the shareholder to sign over the stock certificate to the person the shares will be transferred to.
There are plusses and minuses to choosing the corporation legal structure. One of the most common grievances is the double taxation experienced by shareholders. This double taxation is primarily seen in the C corporation structure. A way to avoid this double taxation is to choose to operate the company under the subchapter S of the IRS code. S corporation eliminate the double taxation by allowing income to pass through the organization directly to the individual shareholders.
Limited Liability Company
Limited Liability Companies (LLC’s) are the favored choice of legal structure for a number of reasons when:
| Legal liability protection is imperative |
| Single taxation is preferred to dealing with the corporate tax liability |
| Entity doesn't qualify for subchapter S status |
The most positive aspect of an LLC is that is provides the legal protection of corporation along with the single taxation. They are very similar to S corporations on the surface however there are a couple of reasons why LLC’s are preferable to S corporations:
| It provides more room for owners to write off business losses in a business that relies on entity-related debt that is incurred |
| It provides greater flexibility to take assets out of the company without incurring unplanned tax liability |
Overall, the decision you make when choosing a legal structure completely depends on your circumstances. Remember to consider legal liability and taxes when making a decision to ensure you are setting your business up for success.
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