Your business’s legal structure has many ramifications. It can determine how much liability your company faces during lawsuits. It can put up a barrier between your personal and business taxes – or ensure this barrier doesn’t exist. It can also determine how often your board of directors must file paperwork – or if you even need a board. [Related article: What to Do if Your Business Gets Sued]
We’ll explore business legal structures and how to choose the right structure for your organization.
A business legal structure, also known as a business entity, is a government classification that regulates certain aspects of your business. On a federal level, your business legal structure determines your tax burden. On a state level, it can have liability ramifications.
Choosing the right business structure from the start is among the most crucial decisions you can make. Here are some factors to consider:
The most common business entity types are sole proprietorships, partnerships, limited liability companies, corporations and cooperatives. Here’s more about each type of legal structure.
A sole proprietorship is the simplest business entity. When you set up a sole proprietorship, one person is responsible for all a company’s profits and debts.
“If you want to be your own boss and run a business from home without a physical storefront, a sole proprietorship allows you to be in complete control,” said Deborah Sweeney, vice president and general manager of business acquisitions at Deluxe Corp. “This entity does not offer the separation or protection of personal and professional assets, which could prove to become an issue later on as your business grows and more aspects hold you liable.”
Proprietorship costs vary by market. Generally, early expenses will include state and federal fees, taxes, business equipment leases, office space, banking fees, and any professional services your business contracts. Some examples of these businesses are freelance writers, tutors, bookkeepers, cleaning service providers and babysitters.
A sole proprietorship business structure has several advantages.
The sole proprietorship is also one of the most common small business legal structures. Many famous companies started as sole proprietorships and eventually grew into multimillion-dollar businesses. These are a few examples:
A partnership is owned by two or more individuals. There are two types: a general partnership, where all is shared equally, and a limited partnership, where only one partner has control of operations and the other person (or persons) contributes to and receives part of the profits. Partnerships can operate as sole proprietorships, where there’s no separation between the partners and the business, or limited liability partnerships (LLPs), depending on the entity’s funding and liability structure.
“This entity is ideal for anyone who wants to go into business with a family member, friend or business partner – like running a restaurant or agency together,” Sweeney said. “A partnership allows the partners to share profits and losses and make decisions together within the business structure. Remember that you will be held liable for the decisions made as well as those actions made by your business partner.”
General partnership costs vary, but this structure is more expensive than a sole proprietorship because an attorney should review your partnership agreement. The attorney’s experience and location can affect the cost.
A business partnership agreement must be a win-win for both sides to succeed. Google is an excellent example of this. In 1995, co-founders Larry Page and Sergey Brin created a small search engine and turned it into the leading global search engine. The co-founders met at Stanford University while pursuing their doctorates and later left to develop a beta version of their search engine. Soon after, they raised $1 million in funding from investors, and Google began receiving thousands of visitors a day. Having a combined ownership of 11.4% of Google provides them with a total net worth of nearly $226.4 billion.
Business partnerships have many advantages.
Partnerships are one of the most common business structures. These are some examples of successful partnerships:
A limited liability company (LLC) is a hybrid structure that allows owners, partners or shareholders to limit their personal liabilities while enjoying a partnership’s tax and flexibility benefits. Under an LLC, members are shielded from personal liability for the business’s debts if it can’t be proven that they acted in a negligent or wrongful manner that results in injury to another in carrying out the activities of the business.
“Limited liability companies were created to provide business owners with the liability protection that corporations enjoy while allowing earnings and losses to pass through to the owners as income on their personal tax returns,” said Brian Cairns, CEO of ProStrategix Consulting. “LLCs can have one or more members, and profits and losses do not have to be divided equally among members.”
According to TRUiC, the cost of forming an LLC comprises the state filing fee and can range from $40 to $500, depending on your state. For example, if you file an LLC in New York, you must pay a $200 filing fee and a $9 biennial fee, according to LLC University, and file a biennial statement with the New York Department of State.
Although small businesses can be LLCs, some large businesses choose this legal structure. The structure is typical among accounting, tax, and law firms, but other types of companies also file as LLCs. One example of an LLC is Anheuser-Busch, one of the leaders in the U.S. beer industry. Headquartered in St. Louis, Anheuser-Busch is a wholly owned subsidiary of Anheuser-Busch InBev, a multinational brewing company based in Leuven, Belgium.
Here some other well-known examples of LLCs:
The law regards a corporation as separate from its owners, with legal rights independent of its owners. It can sue, be sued, own and sell property, and sell the rights of ownership in the form of stocks. Corporation filing fees vary by state and fee category.
There are several types of corporations, including C corporations, S corporations, B corporations, closed corporations, and nonprofit corporations.
Corporations enjoy several advantages.
This structure is ideal for businesses that are further along in their growth, rather than a startup based in a living room. For example, if you’ve started a shoe company and have already named your business, appointed directors and raised capital through shareholders, the next step is to become incorporated. You’re essentially conducting business at a riskier, yet more lucrative, rate. Additionally, your business could file as an S corporation for the tax benefits. Once your business grows to a certain level, it’s likely in your best interest to incorporate it.
These are some popular examples of corporations:
Learn more about how to become a corporation.
A cooperative (co-op) is owned by the same people it serves. Its offerings benefit the company’s members, also called user-owners, who vote on the organization’s mission and direction and share profits.
Cooperatives offer a couple main advantages.
Forming a cooperative is complex and requires you to choose a business name that indicates whether the co-op is a corporation (e.g., Inc. or Ltd.). The filing fee associated with a co-op agreement varies by state.
An example of a co-op is CHS Inc., a Fortune 100 business owned by U.S. agricultural cooperatives. As the nation’s leading agribusiness cooperative, CHS reported a net income of $422.4 million for fiscal year 2020. These are some other notable examples of co-ops:
The five types of business structures are sole proprietorship, partnership, limited liability company, corporation and cooperative. The right structure depends mainly on your business type.
For new businesses that could fall into two or more of these categories, it’s not always easy to decide which structure to choose. Consider your startup’s financial needs, risk and ability to grow. It can be challenging to switch your legal structure after registering your business, so give it careful analysis in the early stages of forming your business.
Here are some crucial factors to consider as you choose your business’s legal structure. You should also consult a CPA for advice.
Where is your company headed, and which type of legal structure allows for the growth you envision? Turn to your business plan to review your goals and see which structure best aligns with those objectives. Your entity should support the possibility for growth and change, not hold it back from its potential. [Learn how to write a business plan with this template.]
When it comes to startup and operational complexity, nothing is more straightforward than a sole proprietorship. Register your name, start doing business, report the profits and pay taxes on it as personal income. However, it can be difficult to procure outside funding. Partnerships, on the other hand, require a signed agreement to define the roles and percentages of profits. Corporations and LLCs have various reporting requirements with state governments and the federal government.
A corporation carries the least amount of personal liability since the law holds that it is its own entity. This means creditors and customers can sue the corporation, but they can’t gain access to any personal assets of the officers or shareholders. An LLC offers the same protection but with the tax benefits of a sole proprietorship. Partnerships share the liability between the partners as defined by their partnership agreement.
An owner of an LLC pays taxes just as a sole proprietor does: All profit is considered personal income and taxed accordingly at the end of the year.
“As a small business owner, you want to avoid double taxation in the early stages,” said Jennifer Friedman, principal at Rivetr. “The LLC structure prevents that and makes sure you’re not taxed as a company, but as an individual.”
Individuals in a partnership also claim their share of the profits as personal income. Your accountant may suggest quarterly or biannual advance payments to minimize the effect on your return.
A corporation files its own tax returns each year, paying taxes on profits after expenses, including payroll. If you pay yourself from the corporation, you will pay personal taxes, such as those for Social Security and Medicare, on your personal return.
If you want sole or primary control of the business and its activities, a sole proprietorship or an LLC might be the best choice. You can negotiate such control in a partnership agreement as well.
A corporation is constructed to have a board of directors that makes the major decisions that guide the company. A single person can control a corporation, especially at its inception, but as it grows, so does the need to operate it as a board-directed entity. Even for a small corporation, the rules intended for larger organizations – such as keeping notes of every major decision that affects the company – still apply.
If you need to obtain outside funding from an investor, venture capitalist or bank, you may be better off establishing a corporation. Corporations have an easier time obtaining outside funding than sole proprietorships.
Corporations can sell shares of stock and secure additional funding for growth, while sole proprietors can obtain funds only through their personal accounts, using their personal credit or taking on partners. An LLC can face similar struggles, although, as its own entity, it’s not always necessary for the owner to use their personal credit or assets.
In addition to legally registering your business entity, you may need specific licenses and permits to operate. Depending on the type of business and its activities, it may need to be licensed at the local, state and federal levels.
“States have different requirements for different business structures,” Friedman said. “Depending on where you set up, there could be different requirements at the municipal level as well. As you choose your structure, understand the state and industry you’re in. It’s not ‘one size fits all,’ and businesses may not be aware of what’s applicable to them.”
The structures discussed here apply only to for-profit businesses. If you’ve done your research and you’re still unsure which business structure is right for you, Friedman advises speaking with a specialist in business law.
Max Freedman and Matt D’Angelo contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.