Choosing a Legal Structure for Your Small Business
Are your personal assets at risk if a customer sues you after slipping in your store? That depends on your business’s legal structure. Must your business file its own tax return? That depends on your business’s legal structure. Can you issue stock? Once again, that depends on your business’s legal structure.
As you can see, choosing a legal structure is a very important task, but unfortunately, many small businesses don’t think about it. What happens if you don’t select anything? Your business is considered a sole proprietorship (if you are the only owner) or partnership (if there are multiple owners). Being a sole proprietorship or partnership is not necessarily bad, but it is better to consider all of your options and see which one is most appropriate than to have the choice made by default.
Legal structures include:
- Sole proprietorship. The main feature of a sole proprietorship is that there is no separation between the business and the owner. Your business does not pay its own taxes – its income and expenses are recorded on your personal income tax return. This is called pass through taxation. You are also personally responsible for the company’s liabilities, so if the company is sued or does not pay a debt, your personal assets can be seized. While its ease in formation (no paperwork is required) makes sole proprietorship an appealing option, don’t forget to consider your risk. If, for example, your business consists of teaching sword swallowing, it may be better to choose a structure that provides liability protection.
- Partnership. Partnerships have the same features as sole proprietorships, only there is more than one owner. Starting a business with other people can be tricky. To minimize conflict, it is a good idea to create a partnership agreement, whose purpose is to govern the relationship between the partners. For example, the partnership agreement can determine how the profits are divided and decisions are made, as well as what happens when one partner wants out of the business.
- C corporation. Most large businesses are C corporations. Unlike sole proprietorships and partnerships, corporations are legally separate from their owners. Thus, owners are not personally liable for the corporation’s liabilities. However, C corporations are also subject to double taxation. The company must pay taxes on its profits, and owners must pay taxes on the profit distributions they receive from the business. While C corporations are able to issue stock, which is helpful when financing is needed, they must also register with the state and follow stringent regulations. For example, corporations must file annual reports, create by-laws, and use a double entry bookkeeping system to record transactions.
- S corporation. S and C corporations are similar in many ways (for example, they both provide personal liability protection and are required to register with the state and hold meetings), but S corporations are not, for the most part, subject to the double taxation that C corporations are. S corporations are also more limited in the amount and type of stock they can offer and who can purchase the stock. However, since issuing stock is often not a major concern for small business owners, many find S corporations more appealing.
If you are not sure what your business should be, you may want to consult with a lawyer and/or accountant. The fees they charge are small compared to the benefit you will get from having the right legal structure for your business.
- Limited liability company (LLC). A limited liability company can have one or several owners, who are called members. As you can probably guess from the name, members of a LLC have limited liability, just like corporations. However, LLCs are not subject to double taxation – members record the business’s profits and losses on their personal income tax returns. Although forming an LLC still requires filling out paperwork, it is generally easier to form than a corporation.