If you are not sure which legal structure to choose for your business, you are not alone.
Most business owners are not legal experts, and while they may have heard of partnerships, LLCs, suburban companies, and the like, it is difficult to know which to use.
So in this tutorial, we’re going to break down the six main types of legal structure in the US:
- one-man business
- C Corporation
- S Corporation
- Limited Liability Company (LLC)
We will see how each one works, the pros and cons of choosing each one, and situations where each could be helpful. In the end, you will have a clear idea of what your options are and what is right for your company.
The examples we are using are for US companies. Of course, each country has its own legal system and some of the corporate structures used in other countries differ, as do tax rules and business creation processes.
If you’re not based in the United States, this article will still give you an overview of the different ways businesses can be structured. However, you will need to check your government website or a local legal expert for more specific details for your country.
1. Sole ownership
How it works
This is the standard option that most business owners use when they are just starting out. No need to submit forms to set it up – if you are in business, you are a sole proprietor. You simply declare your income on your personal tax return and pay any taxes or other liabilities yourself.
Being a sole proprietorship doesn’t mean you have to be a one-person business. You can still hire employees – the “only” part just means you can’t share ownership of the company with anyone else. You are the sole owner and legally responsible for all business.
Simplicity is the big advantage of this method. You can start without any problems. When you start things like hiring employees and registering a business name, you have to file more paperwork, but when you’re starting out on your own it’s very easy.
It can also have tax benefits. When you register as a business, you must pay business tax and then personal income tax on any salaries or other income that you pay yourself. As a sole proprietorship, you only pay once. And if your business loses money, you can deduct those losses from other income.
You have unlimited personal liability. All of the company’s debts are your debts. Suppose you run an IT company and accidentally delete your corporate client’s valuable customer information. The customer could sue you for millions, and to pay you might have to clean up your bank account and sell your home. On the other hand, with some other structures, you are protected from total liability.
It can also be difficult to grow as a sole proprietorship because you cannot give shares to other investors. Many of the options we examined in our last series on financing a business resulted in other people being invited to invest in your business. As a sole proprietor, this would not be possible. You need to change your structure before you can access these funding options.
How it works
A partnership is similar to a sole proprietorship but allows two or more people to do business together. You pool your money and go into business by signing a partnership agreement providing details such as; who receives the profit share.
There are two main types. A general partnership is easy to set up, but each partner has unlimited liability, just like a sole proprietorship. Establishing and running a limited partnership is more complicated and costly, however, some partners may have limited liability, which means they cannot lose more than the amount they have invested in the company.
General partnerships are relatively easy and inexpensive to set up (although limited partnerships can be more complex). They are a great way for multiple founders to pool their money and start a business, and they can also be a great way to attract new talent by offering them an in-company partnership.
You also have the same tax advantage as a sole proprietorship: the company itself does not pay any taxes. You will need to file a tax return, but for informational purposes only. Each partner declares his share of the company’s profit or loss from his personal tax return.
As a sole proprietorship, we’ve seen that you are liable for your company’s debts. The same goes for a general partnership, but it is even riskier because you are not only liable for debts you incur but also those your partners incur.
Partnerships can also create conflicts over profit sharing. In general, they are evenly distributed among the partners. So what if you put in extra hours bringing in new customers while your partner isn’t contributing? A comprehensive partnership agreement that covers many potential areas of conflict can be helpful, but there is still a lot of leeways to fall out with your business partners.
How it works
A cooperative is owned by the individuals or companies who use its services. The Associated Press (AP) is a cooperative owned, for example, by news organizations that benefit from their stories. Credit unions are also cooperatives owned by their customers. Other examples are Land O’Lakes and Ace Hardware.
To start a cooperative, you need to find a group of potential members whose needs you can meet, discuss strategy and come up with a business plan. The United States Small Business Administration has a guide to starting a cooperative, including details on how to get started.
A cooperative is a democratic structure that can be great for getting a large number of people involved and making them feel like they are part of the company. You also benefit from the expertise of these people.
Cooperatives are generally not taxed on their profits at the federal level; The individual members pay taxes on the dividends they receive. You may also be eligible for government grants.
Democracy has its own challenges. When you have dedicated, active members who take part in running the cooperative this can work very well. If you don’t, your business could suffer. One member with one vote means the control is shared among all owners. Likewise, the profits are distributed equally, which means a relatively small share for each individual member. It is difficult to raise money as a cooperative fund because large investors can be put off by having to share control with so many other people.
4. C Corporation
How it works
As a company, it is an independent legal entity owned by shareholders. You need to register your company and submit the “Articles of Association” to the State Secretariat of your state, as well as obtain business licenses and permits.
There are two main types: C Corporations and S Corporations. This distinction mostly relates to how they are treated under tax law. We’ll look at C Corporations first.
The main benefit is that it is a limited liability – in most cases, you can lose all of the money you invested in the company, but no more. There is a strict legal line between your personal and business assets. You can only be held personally liable in certain circumstances, such as willful fraud.
Companies can have an unlimited number of shareholders. This gives them great flexibility in the ownership structure and makes them more attractive to potential investors.
Businesses are complex, expensive to set up, and there is a lot of ongoing administration and paperwork. You need to set up a board of directors and hold annual meetings and meet other requirements.
Companies are also subject to “double taxation”. – The corporation pays a tax on the income it generates and you are taxed separately for every salary or dividend you take out of the company.
5. S Corporation
How it works
An S Corporation is a special type of corporation that takes advantage of a tax regulation: it gets its name from the section of the tax class under which it falls. The way S Corporations are formed means they generally don’t pay federal income taxes, but rather the profits are passed directly on to shareholders who declare their tax returns themselves.
If you choose to form an S Corporation, like a C Corporation, you have limited personal liability. You also get the tax benefit of sole proprietorships and partnerships, where the corporation itself does not pay state income tax and instead declares the income on your personal income tax.
(Note, however, that this is not always beneficial. The highest income tax rate is higher than the corporate tax rate, so you must weigh this when deciding which tax structure to use.)
S companies must meet additional criteria in order to qualify for tax treatment. One caveat is that you can’t have more than 100 shareholders, which can cause problems as a company grows. For example, it is common for companies to give their employees a stash, which would be very difficult in an S corporation. And you couldn’t hold an IPO as an S Corporation.
The IRS has also dealt particularly intensively with S Corporations in recent years. Special attention is paid to how much compensation you pay your employees. Hence, you need to proceed carefully to ensure that you meet all of the requirements of the IRS.
6. Limited Liability Company
How it works
Our final structure, the limited liability company, combines the limited liability of a company with the tax characteristics of a partnership. You have set it up by submitting statutes to the State Secretariat of your state like a corporation. The owners of an LLC are referred to as “members” instead of shareholders.
As the name suggests, your personal assets are shielded from the company’s debts and liabilities. In the event of bankruptcy or legal action, your personal liability is limited.
The corporations also benefit from the tax treatment of partnerships and corporations, where the corporation itself is not taxed at the federal level and the income is instead “passed on” to the individual members for disclosure in their personal tax returns.
Unlike a corporation, an LLC has a finite lifespan and in many states must be dissolved if a member leaves. The rules are different and you can include changes in your company agreement, but the consistency and stability of a company are still lacking.
LLCs also have less flexibility than corporations in how they issue stocks. It is complex for companies to issue stock options to employees and they cannot go public. Venture capitalists also typically don’t invest in LLCs, so the structure can hold back growth.
If you want to change the legal structure of your company, the next step is to speak to a lawyer for personal advice. In this tutorial, you learned about the most important options and their advantages and disadvantages. You should now have a good general idea of what would work for your business. But it is a complex area and it is worth seeking professional advice depending on your particular situation.
The steps for changing your business structure also vary depending on the country you are based in – and within the United States, they vary by state. For example, if you want to incorporate a corporation, you need to go through your state government – it is usually handled by the foreign minister’s office. The US government portal USA.gov has links to each state website so you can find more information about the rules of inclusion in your state.
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