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Small Business Legal Structures: What You Need to Know

Finance
Article
08/02/2019

Every business is required to establish a legal structure, whether there's one employee or 10,000. A legal structure is a recognized category of organization from a legal perspective that influences how your business will operate regarding taxation, recordkeeping, and the risk exposure of your personal assets.

Choosing the best legal structure for your business

Choosing among the array of business legal structures is one of the first decisions you'll make as a business owner. Although you may be chomping at the bit to get started with the fun stuff like marketing and sales, take the time to consider the options of how to set up your business's most fundamental component.

Factors to consider when choosing a legal structure

Situations and business needs vary among entrepreneurs, and choosing the best legal structure for your new business early on can save time, money, and headaches down the road. There are four key considerations to factor into your decision:

The industry your business is in

When it comes to choosing one of the small business legal structures for your startup, some industries come with a higher amount of risk and, consequently, vulnerability to lawsuits than others. A graphic designer working as a freelancer is going to have a different level of risk than a group of attorneys opening a firm together, and both parties will have different legal needs than an equipment manufacturer arranging complicated contracts with large suppliers and vendors. The inherent risk within your industry will influence which legal structure is the best fit for you.

The amount of protection you want for your personal assets

On the same thread as risk, you need to figure out how vulnerable your personal assets might be should you get sued. Lawsuits can come from customers, vendors, employees, and even landlords. Each legal business structure comes with varying levels of personal asset protection.

The tax implications of each legal structure

Each business structure carries its own taxation responsibilities. Variables include whether the business is considered a separate entity from the ownership, the schedule for paying taxes, and how the tax liability is calculated. There are also different forms required by the IRS when taxes are filed.

Your firm's growth plans

You can change your business's legal structure down the road, but you should put some thought into both the scale and pace of your future growth. You might be the sole employee of a freelance business now, but do you envision expanding into a larger organization with employees and more services? Or maybe you're a single shop with plans for rapid growth and franchising. What happens when you're ready to leave the business? Would you like to have a business legacy to pass along, or are you okay if the doors are shuttered when you're no longer involved? Your answers to questions like these can help determine which business legal structure is ideal for you.

The different types of business legal structures

There are five different types of business legal structures, and selecting the right one can give you the right balance of cost, legal protections, and benefits. Each comes with its own set of advantages and disadvantages.

Sole proprietorships

More than 25.5 million sole proprietorships filed with the IRS in the 2016 tax year (the most recent data available). There’s also a growing independent workforce emerging. Also referred to as individual entrepreneurship or simply proprietorship, sole proprietorship is the simplest form of a business legal structure and a natural choice for independent workers. If you become a sole proprietor, prepare to include your business and income expenses on your personal tax return.

Advantages of a sole proprietorship

  • This legal structure is simple to set up, with minimal costs.
  • Sole proprietorships have low organizational and operating costs (you retain complete control over decision-making power for your business).
  • You can use business losses and expenditures to offset income.
  • Filing taxes is simpler: You don't have to file a separate tax return for the business, as profits and losses are passed through to the sole owner.
  • There are few formal legal requirements.
  • You may be able to deduct 20% of your business income with the 20% pass-through deduction under the Tax Cuts and Jobs Act.

Disadvantages of a sole proprietorship

  • Personal assets have unlimited exposure (you may consider an umbrella policy to help protect yourself).
  • You are personally responsible for the debt and financial obligations of the business.
  • Getting a business loan or attracting support from investors may be difficult.

Partnership

If you're working with others on your startup, you may want to consider either a general or limited partnership. Each member of a general partnership shares liability. Limited partnerships are characterized by including a general partner with unlimited liability, and partners with maximum liabilities that match their investment in the business.

Advantages of a partnership

  • Partnerships are relatively easy to set up.
  • A larger breadth of leadership expertise can be found than with just one person.
  • Financial burdens are shared, and having more people equates to a greater ability to raise funds and access cash.
  • The business isn't taxed as a separate entity. Rather, each partner files profits and losses on a personal tax return.
  • Partners may be able to deduct 20% of their business income with the 20% pass-through deduction under the Tax Cuts and Jobs Act.

Disadvantages of a partnership

  • In addition to your own exposure, creditors can go after one or all partners, meaning you may also be liable for the activities of one of the partners.
  • You must share decision-making control with others.
  • You'll have to create a formal exit strategy to avoid potential complications should you sell the business in the future.

Limited liability company

Another popular structure among startups is the limited liability company (LLC) because it works like a hybrid of a sole proprietorship and a corporation. Like corporations, an LLC limits the personal liability of the owners. That said, it's important to note that some of the liability benefits of LLCs have been overridden by the courts in cases of fraud or misrepresentation.

Advantages of an LLC

  • An LLC is a separate entity from the owners. You can lose the money invested in the company, but your personal assets are mostly protected from debts and lawsuits.
  • You are the sole representative of an LLC, meaning you get to make your own decisions.
  • You may be able to deduct 20% of your business income with the 20% pass-through deduction under the Tax Cuts and Jobs Act.
  • There are relatively affordable startup fees ranging from $40 to $500, depending on your state.
  • Profit sharing is at the discretion of the owner(s).

Disadvantages of an LLC

  • Profits may be subjected to self-employment tax.
  • Unlike a sole proprietorship or partnership, you have to pay annual fees to keep the LLC in good standing.
  • Because the LLC is a separate business entity from the owner, careful attention must be paid to keep personal and business funds separate and well documented.
  • Owners may have to pay individual unemployment compensation.

Types of corporations

There are two different types of corporations: C corporations and an S corporations. Owners are called stockholders or shareholders. The corporation's activities — marketing, sales, revenues, expenses, assets, and liabilities — are legally separated from the owners (shareholders). Regardless of which is best for you, incorporating a business shares some common advantages and disadvantages.

Advantages of a corporation

  • Being an independent legal entity, corporations are separate from you, the owner, eliminating the risk to your own personal assets that legal proceedings or credit issues could bring.
  • You can issue shares to raise funds.
  • Transfer of ownership is simplified.
  • If something happens to the founder, the corporation continues to operate as before, providing longevity to the business.
  • Incorporating adds legitimacy to your company.

Disadvantages of a corporation

  • Expect to pay legal fees to set up a corporation and for annual statements and resolutions.
  • Corporations are typically more expensive to start than other business legal structures. There are startup fees and annual fees.
  • You must adhere to a corporate structure, with a board of directors and corporate officers.
  • A corporation is more complex to manage. It must provide annual reports, and careful accounting records must be maintained.

C-corp

Corporations set up as C-corps have their own tax brackets. This means they are taxed separately from the owners. When you think of large U.S. companies, most are generally C-corps.

Advantages of a C-corp

  • There are no shareholder limits, and shareholders can come from anywhere in the world.
  • Because there are no shareholder limits, there's unlimited growth potential.
  • C-corps have the widest range of deductions and expenses allowed by the IRS.

Disadvantages of a C-corp

  • Double taxation is often cited as one of the biggest disadvantages of a C-corp. Shareholders must declare dividends received from the corporation as income on their personal tax returns even though the C-corp has already paid taxes on that profit before the distribution.
  • Reporting can be cumbersome, as annual reports along with minutes of board member and shareholder meetings must be recorded and provided.

S-corp

S-corps are named for Subchapter S of the IRS Code, under which they're taxed. This involves setting up a C-corp and then having all shareholders file a Form 2553 to the IRS within two months and 15 days of the setup.

Advantages of an S-corp

  • Income is allowed to "pass through" to shareholders, and shareholders only pay taxes on their allocated income on their personal tax returns.
  • Tax credits, losses, and deductions also pass through to the shareholders.
  • S-corps avoid the double taxation penalty.

Disadvantages of an S-corp

  • S-corps are limited to 100 shareholders.
  • Owners (shareholders) must be individuals and residents of the United States.
  • The company must be a U.S.-based organization.

As you explore which business legal structure is best for you, you may want to seek business incorporation services. These can help you file the correct paperwork, obtain your federal and state ID numbers, and adhere to the necessary requirements — and to get you started on your exciting and rewarding entrepreneurial path.

This website contains articles posted for informational and educational value. Paychex is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, Paychex. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant.