How to Choose the Best Legal Structure for Your Business – Pros & Cons
Are you thinking about turning your latest idea into a business venture? You’ll need to do a lot of work to get off the ground. The Small Business Administration‘s 10-point checklist for budding entrepreneurs is a great place to start. It ticks off a list of crucial to-dos for anyone in the early stages of business formation:
Pro Tip: I’d add another point: Keep looking for ways to reduce your small business expenses. That’s more of an ongoing obligation, but its importance is impossible to overstate, and it’s never too early to get started.
Number five on that list (determining your company’s legal structure) is crucial, with plenty of pitfalls to avoid. Let’s look at the most common business structures available to U.S.-based entrepreneurs – and a handful of less-common structures too. You’ll learn the basic attributes, advantages, and disadvantages of each structure. Afterward, you’ll be able to properly assess which option is right for you.
A sole proprietorship (sole prop) is the simplest and least formal business structure available to U.S. business owners. By definition, it’s also the least conducive to growth. All sole props share some essential attributes:
Think of a partnership as a multimember sole proprietorship. The Small Business Administration describes partnerships as “a single business where two or more people share ownership” and “each partner contributes to all aspects of the business, including money, property, labor or skill,” while sharing “in the profits and losses of the business.” Like sole proprietors, partners are by default personally liable for partnership debts and obligations.
Like sole proprietorships, partnerships are informal. “Generally, partnerships do not require any filings with state agencies,” says Shawn Toor, a business law attorney with Seattle-based Williams Kastner. “A partnership can be formed merely by the act of two or more people agreeing to carry on business and share in the profits and ownership control.”
Partnership Agreements
Most partnerships are controlled by contracts known as partnership agreements. Partnership agreements govern matters like:
You can find generic partnership agreement templates online and modify them to your partnership’s needs. However, these templates frequently leave out important eventualities that could affect your interest in the partnership – or the partnership’s very existence – going forward. For instance, a carelessly drafted partnership agreement could allow one partner to unilaterally bind the entire partnership, possibly against the other partners’ wishes.
It’s therefore highly advisable to retain an attorney to draw up a customized partnership agreement on your behalf. If your budget doesn’t allow for this at the outset, revisit the situation as soon as possible. Your partner(s) should be amenable to creating a customized partnership agreement to protect their own interests.
There are three main types of partnerships. You’ll designate which type of partnership you’ve chosen in the partnership agreement.
General Partnership
A general partnership is the most common and straightforward type of partnership. Typically, general partners share equally in the partnership’s profits and liabilities, take on equitable duties, and have equal voting rights. The partnership agreement controls situations in which partners’ interests and duties diverge. For instance, many partnerships assign executive duties to a single managing partner. Others dole out profit shares according to seniority, with longer-serving partners taking a greater share of the entity’s net income.
Limited Partnership
A limited partnership (LP), also known as a limited liability partnership, allows for a class of “limited partners” who essentially function as passive investors in the venture. Limited partners have little or no influence on the partnership’s decision-making processes and day-to-day management activities. They are not personally liable for the partnership’s debts or obligations. And they receive profit or loss shares proportional to their interest, which is usually smaller than that of general partners.
LPs are more complicated than general partnerships. They are suitable for larger, capital-intensive ventures that attract lots of investors – not so much for small, two- or three-person ventures, which are easier to manage through general partnerships.
On the bright side, they’re more discreet than traditional corporations. “The LP agreement is typically a privately signed document,” says Jason Powell, a corporate law attorney at Missoula, Montana-based Bjornson Jones Mungas, PLLC. “[LP agreements are] usually not recorded or available to the public, which allows for anonymity if desired.”
Joint Venture
A joint venture is a time- and scope-limited general partnership. It’s ideal for one-off projects that require pooled resources, such as a commercial real estate development. Partners in a joint venture can convert the enterprise into a traditional general partnership by amending the partnership agreement.
A corporation, sometimes known as a C corporation or C-corp, is defined by the Small Business Administration as “an independent legal entity owned by shareholders.”
“Creating a corporation is like creating a human being,” says Toor. “Corporations can be sued, sue others, hold property, [and exist within] a partnership.”
According to the SBA, “the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.” Compared with sole proprietorships and partnerships, whose members are held personally liable for business debts and activities, this is a major advantage for corporate shareholders.
C-corps are subject to greater regulation than partnerships and sole proprietorships. In addition to onerous incorporation requirements, C-corps face ongoing regulatory burdens, such as the requirement that they hold annual shareholder and director meetings. If you’re running a small enterprise with limited overhead, incorporation could be more trouble than it’s worth. Here’s a look at the basic initial and ongoing steps you’ll need to take to set up a C-corp.
Incorporation Requirements
Corporations must be formally incorporated with state business authorities, typically the Secretary of State office or equivalent. This requires drawing up and filing articles of incorporation, which include basic information about the entity:
You can find low-cost articles of incorporation templates online. However, as with partnership agreement templates, cookie-cutter articles of incorporation aren’t ideal. It’s better to spend more for custom-drafted articles of incorporation that account for a wider range of eventualities specific to your company.
Corporate Operating Agreements
In addition to articles of incorporation, which are required by law, most corporations are governed by operating agreements or bylaws. These documents spell out in detail the way the corporation is to be governed. Like partnership agreements, they’re not mandated by law, but they’re highly encouraged.
Corporate Tax Obligations
Unlike sole props and partnerships, C-corps are not pass-through entities. For tax purposes, they are treated as legally separate entities from their shareholders. They pay federal, state, and sometimes local income tax at corporate rates, which are different than personal income tax rates. They are also subject to different credits and deductions than individual filers. Check with the IRS for more information about corporate tax obligations, including forms required to file.
An S corporation, also known as an S-corp, is a special type of incorporated entity that’s ideal for small to midsize businesses. Like C-corp owners, S-corp owners and shareholders are insulated from personal liability for business debts, obligations, and actions. Unlike C-corps, S-corps are pass-through entities. Their income isn’t subject to corporate income tax – it passes through as distributions to shareholders, who then pay personal income tax at an appropriate rate (usually lower than rates on wage income).
Incorporating and operating an S-corp is an intensive process. Like C-corps, S-corps require articles of incorporation filed with the appropriate authorities, as well as annual shareholder meetings. Operating agreements are also strongly encouraged.
S-corps have a few noteworthy twists:
Extant only since 1977, the limited liability company (LLC) model is the newest common business structure available to U.S. business owners. By some measures, it’s the most flexible.
“LLCs are hybrids between corporations and a partnership,” says Toor. “LLC members have the same rights and limited liability of shareholders in a corporation, and LLCs themselves have the added benefit of being treated like a partnership for tax treatment.”
Tax Treatment
According to the IRS, LLCs can be classified as corporations, partnerships, or sole proprietorships (disregarded entities) for tax purposes. The classification depends on the number of members (shareholders) and those members’ stated preferences (elections).
By default, one-member (single-member) LLCs are treated as disregarded entities, with pass-through business income recorded on members’ personal tax returns (Schedule C or C-EZ). Single-member LLCs can file taxes using members’ Social Security numbers – no EINs required.
LLCs with two or more members are treated as partnerships, regardless of the number of members. However, any LLC – including single-member LLCs – can elect to be treated as a corporation for tax purposes. And even disregarded entities are treated as separate corporate entities for certain tax purposes, such as employment and excise taxes.
Filing and Regulatory Requirements
Like C-corps and S-corps, LLCs are required by law to file articles of incorporation with the appropriate state authorities. Operating agreements are strongly encouraged as well. According to the SBA, state law often leaves LLCs vulnerable to member losses – for instance, when a member dies or resigns from a multimember LLC, the LLC dissolves, and the remaining members must elect to form a new LLC if they wish to remain in business together. Capable business attorneys can draft detailed operating agreements that account for common (and not-so-common) eventualities like this.
Going forward, LLCs’ regulatory burdens are lighter than S-corps’ or C-corps’. “The main difference between an LLC and S corporation is operational flexibility,” says Brian Thompson, a Chicago-based CPA and business attorney. “LLCs are not subject to the requirement of an annual shareholders’ meeting or annual directors’ meeting.”
Most new U.S. enterprises choose one of these five common business structures. I’ve included a lot of information about each here, but if you’re serious about launching a business and need firm guidance on the right structure for your needs, I’d recommend speaking with a business attorney.
And, one more thing. There’s a sixth type of business structure not mentioned here: the cooperative.
According to the Small Business Administration, a cooperative “is a business or organization owned by and operated for the benefit of those using its services. Profits and earnings generated by the cooperative are distributed among the members, also known as user-owners.”
Cooperatives are more commonplace than many consumers realize, especially in the food business. Hundreds of thousands of U.S. consumers regularly shop at grocery cooperatives – member-owned grocery stores that often specialize in organic or natural foods. Millions purchase food products from massive agricultural cooperatives, often without realizing it. Land O’Lakes, a popular consumer dairy brand, is a multibillion-dollar cooperative. Though less recognizable to the average grocery shopper, CHS is even larger, more diversified, and more influential.
All that said, starting a cooperative is very difficult. I’ve been personally involved with two cooperatives and can attest firsthand to the sheer amount of manpower and force of will necessary to get one off the ground. In certain circumstances, a cooperative may be the best business structure for your needs, but it’s not a one- or two-person project.
Which legal business structure is best for your needs?
Categories: Legal, Small Business
Brian Martucci writes about frugal living, entrepreneurship, and innovative ideas. When he’s not interviewing small business owners or investigating time- and money-saving strategies for Money Crashers readers, he’s probably out exploring a new trail or sampling a novel cuisine. Find him on Twitter @Brian_Martucci.
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How to Choose the Best Legal Structure for Your Business – Pros & Cons
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