Small Business Legal Structures: LLC, Corporation, and More
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. Designating a legal structure for your company can also reduce the risk exposure of your personal assets.
Choosing the best legal structure for your business
Choosing a legal structure 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, you should not rush this important first step. Take the time to weigh your options and consider the proper way to set up your business's most fundamental component.
Factors to consider when choosing a legal structure
Situations and business needs vary among entrepreneurs. 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, the nature of your business is an important factor. Some industries are associated with a higher amount of risk and, consequently, are more vulnerable to lawsuits. A graphic designer working as a freelancer will 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 different types of business legal structures, and selecting the right one can give you the proper balance of cost, legal protections, and benefits. Each comes with its own set of advantages and disadvantages.
What are sole proprietorships?
More than 27 million sole proprietorships filed with the IRS in the 2018 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.
What are Partnerships?
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.
What are Limited Liability Companies (LLCs)?
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 and are not beholden to any external shareholders or Board of Directors.
- 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.
What is incorporation and what is an incorporated Business?
There are two different types of corporations: C corporations and 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.
How to incorporate a small business
Incorporating a business is the process of separating the company from your personal assets and forming a new legal entity, known as a corporation. For-profit business ventures or nonprofit organizations can be incorporated, but sole proprietorships cannot. The newly formed corporation will exist independently for legal, tax, and insurance purposes. If you'd like to learn how to incorporate a business, here are the basic steps to follow:
Research state laws on incorporation
If you want to know where to go to incorporate your business, an online search of registration forms for your state will provide a starting point. State of incorporation may be based on a number of factors, including primary business location, tax laws, or local business regulations. To find out how much it costs to incorporate, check with your state for filing fees. Additionally, due to the more complex structure of corporations compared to other business structures, you may want to pay a professional to assist you with the process.
Name the corporation
Check the state register to determine if your company's name is available. If another corporation has already registered that name, you'll need to come up with something new.
Choose the structure
Corporations can be structured as a C-Corp or an S-Corp. Large corporations generally opt for C-Corp status, but you should understand the relative advantages of both, as outlined below. Important differences include how these types of corporations are taxed and the number of permissible shareholders.
Draft Articles of Incorporation and Bylaws
Each corporation must have written articles of incorporation and corporate bylaws. The articles of incorporation must be filed with the state and they provide the information required to register the corporation, such as the name of the business, the type of business, and the legal address. The more detailed corporate bylaws list out legal procedures companies and their directors must follow, including the requirement for an annual shareholders' meeting.
Select Board of Directors and Officers
Corporations must form an independent board of directors and name their corporate officers. The board of directors is responsible for overseeing the business's activity from a high level. The board may also provide guidance to small businesses when needed. The corporate officers are the executive management of the company, responsible for running the business.
Prepare accounting / funding
Set up an accounting system to record the initial funding of your new corporation. You should also open a bank account in the name of the corporation to separate assets. Going forward, corporate cash flows should go through this account.
Apply for Tax ID and file necessary state paperwork
Once your corporation is set up, you'll be able to file for a Federal Employer Identification Number (EIN), which is used as a tax ID. You will also need to register your corporation with the state where you chose to incorporate and pay the required filing fees.
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.
What is a 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.
- Current tax brackets for C Corporations are generally lower than individual income tax brackets.
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.
What is an 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
- Shareholders of S Corporations 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 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 the array of business legal structure and their relative benefits, you may want to seek the expertise of business incorporation services. Incorporation services providers can help you file the correct paperwork, obtain your federal and state ID numbers, and adhere to the necessary legal requirements — all to get you started on your exciting and rewarding entrepreneurial path.