If you’re stuck on the
problem of which legal structure to choose for your business, you’re not alone.
Most business owners are not legal experts, and although they may have heard of partnerships, LLCs, S corporations and the like, it’s hard to know which one to use.
So in this tutorial, we’ll break down the six main types of legal structure in the U.S.:
- Sole proprietorship
- C Corporation
- S Corporation
- Limited Liability Company (LLC)
We’ll look at how each one works, what the pros and cons are of choosing each one, and situations in which each one might be helpful. By the end, you’ll have a clear idea of what your options are, and which one is right for your business.
The examples we’ll use are for U.S. businesses. Each country has its own legal system, of course, and some of the business structures used in other countries are different, as are the tax rules and the processes for setting up businesses. If you’re based outside the U.S., this tutorial will still give you a general idea of the different ways in which businesses can be structured, but you’ll need to check on your government website or with a local legal expert to find more specific details for your country.
1. Sole Proprietorship
How It Works
This is the default option, and it’s what most entrepreneurs use when they're just starting out. You don’t have to file any forms to set it up—if you’re in business, you’re a sole proprietor. You simply declare your income on your personal tax return, and pay any tax bills or other liabilities yourself.
Being a sole proprietor doesn’t mean you have to be a one-person business. You can still hire employees – the “sole” part just means that you can’t share the ownership of the business with anyone else. You’re the sole owner, and legally responsible for the whole business.
Simplicity is a big advantage of this method. You can start up without any hassle at all. If you start doing things like hiring employees and registering a trade name, you’ll have more paperwork to file, but if you’re starting up on your own, it’s very easy.
It can also have tax advantages. If you register as a business, you’ll have to pay business income tax, and then pay personal income tax on any salary or other income you pay yourself. As a sole proprietor, you only pay once. And if your business loses money, you can deduct those losses from other income.
You have unlimited personal liability. Any debts the company runs up are your debts. Let’s say you run an IT firm, and accidentally erase your corporate client’s valuable customer data. The client could sue you for millions, and to pay up you might have to clean out your bank account and sell your house. With some of the other structures, on the other hand, you’re shielded from full liability.
Also it can be hard to scale up as a sole proprietor, because you can't give stock to other investors. Many of the options we looked at in our recent series on Funding a Business involved inviting other people to invest in your business, and as a sole proprietor there would be no way to do that. You’d have to change your structure before you could access those funding opportunities.
How It Works
A partnership is similar to a sole proprietorship, but allows two or more people to go into business together. You pool your funds and go into business by signing a partnership agreement, setting out details such as who gets what share of the profits.
There are two main types. A general partnership is easy to set up, but each partner has unlimited personal liability, as with a sole proprietorship. A limited partnership is more complicated and costly to set up and run, but allows some partners to have limited liability, meaning they can’t lose more than the amount they invested in the business.
General partnerships are relatively easy and cheap to set up (although limited partnerships can be more complex). They’re a good way for several founders to put their money together and form a business, and can also be a great way to attract new talent by offering them partnership in the firm.
They also have the same tax advantage as being a sole proprietor: the business itself doesn’t pay tax. You do have to file a tax return, but for information purposes only. Each partner declares their share of the business’s profit or loss on their personal tax return.
As a sole proprietor, we saw that you’re liable for the debts of your business. The same applies in a general partnership, but it’s even more risky, because you’re liable not only for debts you run up yourself, but also for those your partners incur.
Partnerships can also cause conflict over the sharing of profits. Generally they’re distributed equally between the partners, so what happens if you’re putting in extra hours and pulling in new clients, while your partner is not contributing? A comprehensive partnership agreement that covers a lot of potential areas of conflict can help, but still there’s plenty of scope for falling out with your business partners.
How It Works
A cooperative is owned by the people or companies that use its services. The Associated Press (AP) is a cooperative, for example, owned by the news organizations that benefit from using its stories. Credit unions are also cooperatives, owned by their customers. Other examples include Land O’ Lakes and Ace Hardware.
To set up a cooperative, you’ll need to find a group of potential members whose needs you can serve, and meet with them to discuss strategy and set up a business plan. The U.S. Small Business Administration has a guide to forming a cooperative, including details of how to incorporate.
A cooperative is a democratic structure, which can be great for getting large numbers of people involved and making them feel that they have a stake in the business. You also get the benefits of all those people’s expertise.
Cooperatives are generally not taxed at the federal level on their profits; individual members pay tax on the dividends they receive. They can also be eligible for special government grants.
Democracy has its own challenges. If you have committed, active members participating in the governance of the cooperative, then it can work very well. If you don’t, then the business could suffer. One member one vote means that control is distributed among all the owners. Likewise profits are distributed equally, meaning a relatively small share for each individual member. It can be hard to raise money as a cooperative, because large investors may be put off by the fact that they have to share control with so many other people.
4. C Corporation
How It Works
As a corporation, your company is an independent legal entity owned by shareholders. You have to register your business and file “Articles of Incorporation” with your state’s Secretary of State office, as well as obtaining business licenses and permits.
There are two main types: C Corporations and S Corporations, a distinction that mostly refers to how they're treated under the tax code. We’ll look at C Corporations first.
The main advantage is limited liability—in most cases you can lose any money you've invested in the company, but no more than that. There’s a strict legal line between your personal and business assets. You can only be held personally responsible under certain limited circumstances, such as intentional fraud.
Corporations can have an unlimited number of shareholders. That gives them a lot of flexibility in the ownership structure, and makes them more attractive to potential investors.
Corporations are complex and expensive to set up, and there's a lot of ongoing administration and paperwork. You’ll have to set up a board of directors and hold annual meetings, as well as meeting other requirements.
Also, corporations are subject to “double taxation”—the corporation pays tax on income it generates, and you're taxed separately on any salary or dividends you take out of the business.
5. S Corporation
How It Works
An S Corporation is a special type of corporation that takes advantage of a tax rule: it gets its name from the section of the tax code it falls under. The way S Corporations are set up means that in general they don’t pay any federal income taxes, with the profits instead being passed directly through to the shareholders, who declare them on their own individual income tax returns.
If you choose to incorporate as an S Corporation, you enjoy limited personal liability, as with a C Corporation. But you also enjoy the tax advantage of sole proprietorships and partnerships, where the corporation itself doesn’t pay any federal income tax, and you declare the income on your personal income tax instead. (Note, however, that this is not always an advantage. The top personal income tax rate is higher than the corporate tax rate, so you’ll need to weigh that up when deciding which tax structure to use.)
S Corporations have to meet extra criteria to qualify for the tax treatment. One restriction is that you can’t have more than 100 shareholders, which can create problems when a company starts to grow larger. It’s common, for example, for companies to give some stock to their employees, and that would be very difficult in an S Corporation. And you couldn’t hold an IPO as an S Corporation.
The IRS has also devoted particular scrutiny to S Corporations in recent years. It pays particular attention to things like how much compensation you pay to employees, so you need to step carefully to make sure you meet all the IRS’s requirements.
6. Limited Liability Company
How It Works
Our final structure, the limited liability company, combines the limited liability of a corporation with the tax features of a partnership. You set it up by filing articles of association with your state’s Secretary of State office, as with a corporation. The owners of an LLC are referred to as “members” instead of shareholders.
As the name implies, your personal assets are shielded from the company’s debts and liabilities. In the event of a bankruptcy or lawsuit, your personal liability is limited.
LLCs also benefit from the tax treatment of partnerships and S corporations, where the company itself is not taxed at the federal level, and the income is instead “passed through” to the individual members to be declared on their personal tax returns.
Unlike a corporation, an LLC has a limited lifespan, and in many states it has to be dissolved if one member leaves. The rules vary, and you can make provision for changes in your operating agreement, but it still lacks the permanence and stability of a corporation.
LLCs also have less flexibility than corporations in how they issue stock. It’s complex for LLCs to do things like issue stock options to employees, and they can’t hold IPOs. Venture capitalists will also typically not invest in LLCs, so the structure can hamper growth.
If you want to change the legal structure of your business, the next step is to talk to a lawyer to get personalized advice. In this tutorial, you’ve seen what the main options are, and learned the advantages and disadvantages of each. You should now have a good general idea of what would work for your business. But it’s a complex area, and it’s worth getting professional advice based on your own particular situation.
The steps for changing your business structure also vary depending on which country you’re based in—and within the United States, they vary by state. If you want to form a corporation, for example, you’ll need to go through your state government—it’s usually handled by the office of the Secretary of State. The U.S. government web portal USA.gov has links to each state’s website, so you can get more information on the rules for incorporation in your state.
Your attorney can help
you navigate the system and make all the necessary legal changes. But from
taking this tutorial, you should now know which legal structure makes the most
sense for your business, and whether you need to consider changing your
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