Selecting the best legal structure is a crucial element of running a successful company. If you're just beginning your journey of growing your business it's essential to be aware of the various options.
- The legal structure of your business will determine your taxes, the management and paper requirements, fundraising skills, and much more.
- Partnerships, sole proprietorships, or partnerships can be easy to set up, but they do not provide liability protection.
- Corporate entities may require more effort to get up and running however, they provide security against liability, and in certain cases, they can offer tax benefits that are more favorable.
- This article is written for entrepreneurs who want to know more about the various legal frameworks for business.
The legal structure of your company has a number of implications. It determines the amount of risk your company is exposed to in the event of a lawsuit. It could create an obstacle between personal tax and corporate taxes or make sure that this obstacle doesn't exist. It could also decide the frequency with which the board needs to submit paperwork, or even if you require the board.
We'll discuss legal structures for business and the best way to select the most appropriate structure for your company.
What is a legal business structure?
A legal structure for a business also referred to as an entity for business is a type of government classification that governs specific areas of business. At a national level, your business's legal structure is what determines the tax burden you will have to pay. At a state level, it may result in liability implications.
What is the reason a legal business structure so important?
The choice of the correct organizational structure from the beginning is one of the most important decisions you'll have to make. Here are some aspects to take into consideration:
- Taxes The sole proprietors, the partnership owners, and S corporate owners classify their business earnings as personal revenue. C corporation income is a business income that is separate from the proprietor's own personal earnings. Due to the differing tax rates for personal and business personal incomes. Your structure decision can have a significant impact on the tax burden you face.
- The liability of a limited liability companies (LLC) structures are a way to safeguard you and your assets from being damaged in eventuality of an action. However, the federal government doesn't recognize LLC structures. They are only at a state-level. C Corporations are federal business entity which provides liability protection offered by LLCs.
- Paperwork: Each legal entity has its own tax forms. In addition, if you form your business as a corporation, you'll be required to file the articles of incorporation as well as regularly submit certain government reports. If you form as a partnership for business and run business under a fake name, you'll need submit special forms to support that.
- Hierarchy: Companies require a board of directors. In some states, the board must meet a specified amount of times per year. Corporate hierarchies can also prevent the closure of a business if a company's owner sells shares or quits the business, or if the founder dies. Others structures do not have this security.
- Registration: A legally-sound business structure is also a requirement for the registration of your business in the state you are operating in. You aren't able to obtain an employee identification number (EIN) or get all the required licenses and permits without a formal business structure.
- Fundraising: Your business structure could restrict your ability to raise funds in specific ways. For instance sole proprietorships aren't able to offer stock. This right is usually restricted to corporations.
- Possible consequences for selecting the wrong business structure: Your initial decision on the best business structure is essential however, you are able to change your business's structure in the future. But the process of changing your business structure may be a messy complicated process that could result in tax implications and the unintentional dissolution of your company.
Different types of business structures
The most commonly used forms of business entity include sole proprietorships, partnerships as well as limited liability companies, cooperatives and corporations. Find out more about each kind of legal arrangement.
Sole proprietorship
Sole proprietorships are the most simple company structure. If you establish the sole proprietorship, only one individual is responsible for the entire company's earnings and obligations.
"If you'd like to be the sole proprietor and manage a business from your home with no physical location it is possible to be a sole proprietorship. It allows you to have total charge," said Deborah Sweeney who is vice general manager and vice president for business acquisitions with Deluxe Corp. "This entity is not able to provide separation or protection of your personal as well as professional property, and this can be a problem when your business expands and more aspects make you responsible."
Costs for a proprietorship vary based on market. The majority of the time, the early costs include federal and state taxes such as tax, leases on business equipment offices, banking fees, as well as any professional services you contract with your business. Examples of these companies include freelance writers, tutors bookkeepers, bookkeepers, babysitters, and cleaning service providers.
A sole proprietorship structure for business is a good choice for a variety of reasons.
- Simple setup It is the easiest legal entity to establish. If you are the sole owner and you are the owner of your business then this could be the ideal arrangement. There's not much formalities to worry about since you don't have executives or partners.
- Low cost: Costs differ according to state, however typically licensing fees, as well as tax on business are usually the main costs associated with owning a business.
- Tax deduction: As you and your business are one entity, you could be eligible for specific sole proprietor tax benefits for example, the health insurance deduction.
- Simple exit: Forming an LLC is simple as is completing one. If you are a sole owner is able to dissolve your company at any point, without formal papers needed. For instance, if you begin a daycare center and decide to shut it down, the business, stop operating the daycare and marketing your services.
A sole proprietorship among the more commonly used legal structures for small-scale businesses. Many well-known companies began as sole proprietorships , and later became multimillion-dollar companies. Here are a few examples:
- eBay
- JCPenney
- Walmart
- Marriott Hotels
Partnership
A partnership is controlled by two or more persons. There are two kinds of partnerships: general partnerships, where everyone shares equally, as well as a limited partnership where one partner is the sole one who has control of the operation and the remaining partner (or people) contributes to and gets some from the profit. Partnerships may operate as sole proprietorships where there is no separation between owners and partners or as limited liabilities partnerships (LLPs) according to the organization's funding and the structure of its liability.
"This structure is perfect for those who want to establish a business along with an individual from the family, friend or business partner - such as operating a restaurant or agency in tandem," Sweeney said. "A partnership permits partners to share the profits and losses and to make collective decisions within the company structure. Be aware that you'll be accountable for the decisions you make as well as the actions taken by the business partners."
Costs for general partnerships differ however, this type of structure is more costly than sole proprietorships because attorneys should scrutinize the partnership agreement. The experience of the attorney and his place of residence can impact the price.
A business partnership agreement has to be a win-win situation for both parties to prosper. Google is a perfect illustration of this. In 1995 founders Larry Page and Sergey Brin developed a tiny search engine and transformed it into the world's most popular search engine. The co-founders were during their time at Stanford University while pursuing their doctoral studies. They left later to create a test model of the search engine. After a short time, they had received $1 million in investment from investors and Google started receiving hundreds of users a every day. With a total ownership of 11.4 percent of Google is an estimated net worth of $226.4 billion.
Business partnerships offer many benefits.
- Simple formation: Similar to the sole proprietorship it is not necessary to file any formalities to fill out for a partnership. If your state allows that you operate under a fake identity ("doing business as," or DBA) then you'll have to file a certificate for conducting business as Partners and create the Articles of Partnership agreement, each of which comes with additional costs. It is common to require an official business license, too.
- Growth potential: You're much more likely to get a business loan if you have multiple owners. Banks may look at two credit histories more than just one, which could be beneficial if you have an unsatisfactory credit score.
- Particular taxation requirements: General partnership have to submit federal tax forms 1065 as well as state tax returns, however they typically do not pay tax on income. The partners share their profits or losses on their own tax returns. If, for instance, you started a bakery along with a partner and organized the business as a general partnership you and your partner are co-owners. Each owner brings their own amount of experience and capital to the company and this affects the partners' business percentage and contributions. If you contributed the largest amount of money to start the company, then you and your partner could decide to keep an increased share of the business and you'll be the most significant owner.
Partnerships are among the most commonly used business structures. Here are some examples of partnerships that have been successful:
- Warner Bros.
- Hewlett-Packard
- Microsoft
- Apple
- Ben & Jerry's
Limited liability company
Limited liability companies (LLC) is an arrangement that allows shareholders, partners, or owners to minimize their personal obligations while benefiting from a partnership's tax benefits and flexibility. Members of an LLC are exempt from personal responsibility for debts of the business when it isn't proven that they behaved in a negligent or illegal way that causes injury to another person while carrying out the business's operations.
"Limited Liability companies" established to give business owners the protection against liability corporations have while allowing their earnings and losses to be passed on to owner as income for their income tax return," said Brian Cairns the Director ProStrategix Consulting. ProStrategix Consulting. "LLCs are able to have at least one member and the earnings and losses don't have to be distributed equally between members."
According to TRUiC the cost for creating an LLC is the state filing fee , which could range from $40 to $500, based on the state you are in. If, for instance, you establish the LLC with New York, you must pay a filing fee of $200 as well as a $9 biennial cost as per LLC University, and file an annual statement to the New York Department of State.
While small-sized businesses are able to be LLCs, a few large companies choose to use this legal form of organization. The form of organization is popular in accounting, tax and law firms, however other kinds of businesses also are registered as LLCs. An illustration that is an example of an LLC would be Anheuser-Busch one of the top companies of the U.S. beer industry. The company's headquarters are at St. Louis, Anheuser-Busch is a wholly-owned affiliate to Anheuser-Busch InBev, a multinational beer company with its headquarters within Leuven, Belgium.
Here are some other Examples of LLCs
- Pepsi-Cola
- Sony
- Nike
- Hertz Rent-a-Car
- eBay
- IBM
The law considers a corporation as distinct from its owners and has legal rights that are independent of the owners. It is able to sue and be sued, as well as own and sell properties, and trade ownership rights by way of stock. Corporate filing fees differ according to state and fee categories.
There are many kinds of companies, such as C-corporations, S-corporations B companies, closed corporations and non-profit corporations.
- C corporations: C companies which are owned by shareholders are taxed as distinct entities. JPMorgan Chase & Co. is a global investment banking and holding company for financial services classified as a C corporation. Because C corporations permit unlimited investors, a lot of larger corporations like Apple, Bank of America and Amazon apply for tax-exempt status.
- S companies: S corporations were designed to serve small companies. They are tax-free as do LLCs and partnerships. Owners also have a limited insurance against liability. Widgets Inc. is an example of an S company that is operating simple: The salaries of employees will be taxed under FICA tax (as are all employee wages) and the distribution of extra profits of the S company does not trigger any additional FICA tax obligations.
- B corporations B corporations, commonly called benefit corporations are non-profit organizations that have a commitment to social responsibility of the company and designed to make a positive impact on society. For instance, the The Body Shop, a cosmetics and skincare company The Body Shop has proven its commitment for a long time to support social and environmental causes which has led to the award of B-corporation status. The Body Shop uses its presence to promote permanent improvement on issues such as domestic violence, human trafficking environmental degradation, climate change and the use of animals in the cosmetics industry.
- Closed corporate: Closed businesses are typically managed by a handful of shareholders, aren't publicly traded and have the protection of limited liability. Closed corporations, often called privately-owned businesses, have greater flexibility than publicly traded businesses. For instance, Hobby Lobby is a closed corporation, which is an privately owned, family-owned company. The shares of Hobby Lobby are not publicly traded. Instead, the stock has been assigned the shares to relatives.
- Companies that are open: These companies are available for trading in a market that is open to the public. Numerous well-known corporations, such as Microsoft as well as Ford Motor Co., are open-minded corporations. Each company has assumed ownership of the business and allows any person to invest in the company.
- nonprofit corporations. Nonprofit companies are created to aid people in some way, and get tax-free status. Examples of nonprofits include such as the Salvation Army, American Heart Association and the American Red Cross. All of these organizations are focused on something different than making profits.
Corporates enjoy a variety of benefits.
- Limit liability: Shareholders aren't personally liable for any claims against the company; they are only responsible for the personal investment they made.
- Continuity: Corporations aren't affected by the death of a shareholder or the transfer of shares by the owners. Your company continues to run indefinitely, something consumers, investors, and creditors like.
- Capital: It's much simpler to get huge quantities of capital multiple investors once your company is registered.
This is a great option for companies that are growing at a faster pace and not a start-up that is based in a home. If, for instance, you've founded a shoe business and you've already created your business with directors, appointed them and raised capital via shareholders The next step is becoming legally incorporated. It's basically conducting business with a higher risk, but more lucrative, cost. Furthermore, your company could be incorporated as an S company to enjoy tax advantages. When your business reaches the point of being able to handle it It's probably that it is in your best interest that you incorporate the business.
Here are some examples of corporate:
- General Motors
- Amazon
- Exxon Mobil Corp.
- Domino's Pizza
- JPMorgan Chase
Cooperative
Cooperatives (co-op) is owned by the same group of people that it serves. The benefits it provides benefit its members, also known as owners of the users, who decide on the mission of the company and its direction, and also share the profits.
Cooperatives have a few main benefits.
- More funding: Cooperatives could receive federal grant that can assist them in starting their business.
- Service and discount: Cooperatives are able to increase their size in business which means they can get discounts on goods and services to their members.
It is a complex process to form a cooperative and requires the name of your business that identifies whether the cooperative is a company (e.g., Inc. or Ltd.). The cost of filing the co-op agreement is different depending on the state.
One example of a co-op can be seen in CHS Inc., a Fortune 100 business owned by U.S. agricultural cooperatives. CHS is the country's top agricultural co-operative, CHS has reported net revenue of $422.4 million in the fiscal year 2020. Here are some other noteworthy examples of cooperatives:
- Land O'Lakes
- Navy Federal Credit Union
- Welch's
- REI
- Ace Hardware
Considerations to make prior to choosing the right business structure
For businesses that are new and could fall within two (or more) of the categories above, it's often easy to choose the best structure for your business. Take into consideration your startup's financial requirements, risks and potential to expand. It may be difficult to alter your legal structure once you have registered your company, so make sure you take your time to analyze it during the initial stages of creating your business.
Here are some important aspects to think about when choosing your legal entity for your business. It is also recommended to consult the advice of a CPA to get advice.
Flexibility
What direction is your company taking and what kind of legal structure will allow the growth you want to see? Check your plan of business to look over your goals and decide which type of structure is most compatible with your goals. Your business should embrace the possibility of expansion and transformation, and not limit the possibilities it has.
Complexity
In terms of startup and operations, there's nothing simpler than the sole proprietorship. You can register your name, begin operating your business, then make a profit and then pay tax on them in the form of personal earnings. But, it is difficult to obtain outside financing. Partnerships are different. Partnerships, for instance require a signed contract to determine the roles of the partners and proportions of profit. LLCs and corporations have different reporting requirements to state governments and federal authorities.
Liability
A business is not subject to the greatest personal responsibility since the law states that it's a separate entity. That means that customers and creditors are able to sue the company however they cannot be granted access to any personal assets belonging to the shareholders or officers. A LLC provides the same protections, but with the tax advantages of sole proprietorship. Partnerships share the responsibility between the partners in accordance with their agreement of partnership.
Taxes
The LLC's owner LLC is taxed in the same way as a sole proprietor Any profit earned is treated as personal income and taxed according to the end of the year.
"As an owner of a small-sized business you'll want to stay clear of double taxation during the initial phases," said Jennifer Friedman Principal at Rivetr. "The LLC structure helps prevent this and ensures that you're not taxed by a corporation and not being an individual."
The partners of the individuals are also entitled to a portion in the partnership's profits for personal use. Your accountant could recommend biannual or quarterly advance payments to reduce the tax consequences.
A business file the tax returns of its employees every year, and pays taxes on profits, after expenses, such as payroll. If you take money from the company, you'll have to pay personal taxes including the taxes applicable to Social Security and Medicare, on your personal tax return.
Control
If you are looking for complete or sole control over the business and its operations such as a sole proprietorship or LLC could be the ideal option. You can discuss this control through a partnership agreement in addition.
A company is designed to have a board of directors which is the one who makes the key decisions that govern the company. A single person has the power to control the company, particularly at the beginning but as it expands and expands, it becomes necessary to be an entity controlled by a board. Even for small companies there are rules that apply to larger companies - like taking notes of each important decision that affects the company - remain in effect.
Capital investment
If you require external funding from an investor such as a venture capitalist, bank or it is possible that you would prefer to form the form of a corporation. Corporations are more adept at getting outside financing as opposed to sole proprietorships.
Corporations are able to sell stock shares to get additional funds to grow and expansion, while sole proprietors are able to access funds through only private accounts using personal credit, or by acquiring partners. An LLC may be similarly challenged, but since it is a separate entity, it's usually not essential to make use of their own financial assets or credit card.
Regulations, permits, licenses and permits
Alongside the legalization of your business it is possible that you will require specific licenses and permits in order to run your business. Based on the type of business and the operations, it might need for a license at state, local as well as federal level.
"States have different requirements for various types of business structure," Friedman said. "Depending on the place you're setting up your business, you may have different rules for municipal entities too. If you are deciding on a structure, be aware of the industry and state that you're working in. There isn't a 'one size fits all', and companies may not know the specifics that apply to them."
The structures mentioned here are applicable only to companies that are profit-oriented. If you've conducted your own research and aren't sure which type of business structure is the best one the way for your business, Friedman advises speaking with an expert in the field of the field of business law.