Legal Structures for Your Business

Starting a business comes with myriad key decisions and responsibilities. One of the most important of these early decisions involves the legal structure of your business. Choosing the right business entity is an important decision that can have significant tax and legal implications, so it's important to make the right choice.

With that in mind, here's an overview of the various structures, and information about where and when each option may make the most sense. Please note that entity descriptions, especially regarding corporations and limited liability companies, are simplified to highlight the main differences that may interest a small business owner.

Sole Proprietorship

If you're looking for something simple and you will be the only business owner, consider a sole proprietorship. You don't have to take any official action to form a sole proprietorship. Simply being self-employed and earning money is enough to give you sole proprietor status. 

A downside of a sole proprietorship is that the owner is personally responsible for the business, both financially and legally. As we'll explore below, other structures provide some degree of separation between the business's activities and the owner's personal finances. With a sole proprietorship, the owner earns all of the income but is personally liable for all debts, a lawsuit can more easily target personal possessions, and it can be more difficult to take on business debt. A sole proprietorship is also more difficult to sell because all assets are tied to the owner.

While sole proprietorship has pros and cons, it is a very popular structure for small businesses with over 25 million sole proprietors operating across the country.

Corporation

A corporation is a shareholder-owned and legally independent business entity that must issue stock, file annual reports, and register with a state government. As opposed to sole proprietorships, there is a degree of separation between the owner(s) and the financial/legal obligations of the business. As a result, corporations are a popular legal entity for businesses, both small and large.

There are two main types of corporations – the S corporation and the C corporation. One key difference is that S corporations are "pass-through" entities, meaning that all profits or losses pass through the corporation and to the owners at the end of each year. The corporation itself does not pay taxes. On the other hand, C corporations pay separate corporate taxes, resulting in "double taxation," meaning taxes are paid twice on the same earnings – once for the corporation and again by the shareholder when earnings are disbursed as income or dividends. 

Many small and medium-sized businesses use the S-type corporate structure since there are no additional tax liabilities. C corporations are commonly used by larger companies with large numbers of shareholders and more complex accounting needs.

Limited Liability Company

A limited liability company (LLC) is similar to an S corporation in that it offers legal protection to the owner(s). LLCs are also pass-through entities, so all profits or losses are assigned to the individual LLC members rather than the corporation. 

Much like corporations, LLCs are created through a multi-step process that includes drafting articles of incorporation, filing annual reports, and registering with a state government. Like S corporations, LLCs can be owned by a single individual (known as a "Single Member LLC") or a larger group of owners. 

In general, LLCs tend to be less expensive to set up and maintain than S corporations while offering similar benefits.

Partnership

A partnership is much like a sole proprietorship but with multiple owners. And like sole proprietorships, earnings flow through to the owners at the end of each year.

One type of partnership is the "general partnership" in which each owner has an equal share of the company, and each owner is equally (and personally) responsible for company operations from a legal perspective.

Another type of partnership is the "limited partnership," in which an additional class of limited partners exists. In limited partnerships, general partners remain personally liable for legal obligations, but limited partners are only liable up to the amount they invested in the partnership.

Compared to corporations and LLCs, partnerships are generally less expensive to maintain over time, though there can be substantial formation costs for some types of partnerships.

Which is right for your business?

Beyond the descriptions in this article, there are other differences that can even vary according to the state in which your company is formed. It's a good idea to consult with a knowledgeable attorney when choosing your company structure. If you decide to choose something other than a sole proprietorship, an attorney can assist you with filing the required paperwork and maintaining any annual filing requirements.