Legal Structures of Small Business: What You Need to Know
Choosing the legal structure of your startup is one of the first decisions you'll make as a business owner, but it isn't necessarily an easy one. While you may be champing 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 from a legal perspective. Situations vary among entrepreneurs, and choosing the best legal structure for your new business early on will save time, money, and headaches down the road. Here are six of the most commonly used legal structures for businesses.
There were 17.9 million solopreneurs in the United States in 2014, according to the 2014 MBO Partners State of Independence Survey, and that number is expected to climb. A sole proprietorship is the simplest legal structure of business, and a natural choice for these individual entrepreneurs. If you become a sole proprietor, prepare to include your business and income expenses on your personal tax return. A benefit of sole proprietorship is the ability to use business losses to offset income, but a major downside is the unlimited liability you'll face. This means your personal assets are fair game if you go bankrupt or are sued.
If you're working with others on your startup, you may want to consider either a general or limited partnership. Understand that each member of a general partnership shares liability and creditors can set their sights on one or all partners. Limited partnerships are characterized by including a general partner with unlimited liability, and partners with maximum liabilities that match their investment in the business. Enjoy some tax perks by filing profits and losses on an informational tax return with your personal tax return when you're a partner. If you're a general partner, keep an eye on any of your peers' activities for which you may be liable.
Minimize personal unlimited liability headaches by forming a corporation for your startup. A corporation is an independent legal entity, which means it is separate from you, the owner. This lessens the risk to your own personal assets that legal proceedings or credit issues could bring. Expect to pay legal fees to set up a corporation and for annual statements and resolutions.
Corporations set up as C-Corps have their own tax brackets, which may be lower than your individual tax bracket. File corporation returns using a Form 1120, but prepare to pay tax at your personal rate on any income received from the corporation. As this legal structure doesn't limit the number of shareholders in a company, it's a good choice for larger businesses.
If you expect your startup will make a profit almost as soon as you launch, consider an S-Corp. 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 setup. Doing this lets income "pass through" the corporation to the shareholders' individual tax returns at the corporation's lower tax rate. Keep in mind that S-Corps are limited to 100 shareholders who must be individuals and residents of the United States.
Limited Liability Corporation (LLC)
Perhaps the legal structure most popular among today's startups is the LLC. Like the other forms of corporations, an LLC limits the personal liability of owners, yet it's important to note that recently some of the benefits of LLCs have been overridden by the courts in cases of fraud or misrepresentation.
LLCs are good choices for startups that like the structure and liability protection of a corporation but don't want the headaches and expenses of minutes and resolutions as you can use operating agreements to make changes when necessary. While there are some tax benefits to an LLC, take note that you may pay tax at your personal rate on self-employment draws from the business.