Selecting a legal structure is one of the most important decisions you will make when starting a new for-profit or nonprofit business. The choice that you make will have a lasting impact on major aspects of your business and your life. The legal structure you select when forming a business will have personal tax and liability implications, and will affect how much it costs to form and operate your business. As an attorney who regularly guides new business owners through this decision-making process, I know just how difficult and confusing it can be to weigh all of your options and select the best structure to advance your goals. That’s why I decided to put together this guide on how to decide what the best legal structure is for your small business.
Types of Business Structures
In this guide, I will discuss three types of legal entities:
- Sole Proprietorships
- Limited Liability Companies
There are advantages and disadvantages to each of these legal structures that you should consider when determining which is right for your business.
Sole proprietorships are by far the simplest and most common form of business structure. A sole proprietorship is an unregistered business that is owned and run by one person, who is known as the sole proprietor. There is no legal distinction between the owner and the business entity. The sole proprietor starts a business and then runs it for his or her own benefit.
Federal Taxes For Sole Proprietorships
Because there is no legal distinction between a sole proprietorship and its owner, the owner will report all business income on their personal income tax return.
Benefits of Choosing a Sole Proprietorship
- The quickest and cheapest form of business entity to start.
- Minimal paperwork required — you often only need to obtain a business license.
- Very few government restrictions and regulations.
- You will control all of the money your business makes.
- Fewer record-keeping requirements than other structures.
- No separate tax return is required for your business.
Disadvantages of Choosing a Sole Proprietorship
- Personal liability for business debts. This means that business creditors can go after your personal assets.
- Harder to get financing because the business’ equity is limited to your personal resources.
- Difficult to transfer ownership of the business.
- May appear less “professional” or “official” to potential clients or customers than the other forms of business entity.
A corporation (Inc.) is a business structure that is created by state statute. Each state has its own statute and requirements for forming a corporation, so you will need to check the requirements in the state in which you are registering before starting a corporation
A corporation is a legal entity that is completely separate from its owner. Corporations can be taxed separately from their owner(s) and held legally liable for corporate acts, and they can also make a profit that is independent of its owners’ income.
Generally, the owners of a corporation are called shareholders, and there is no maximum number of owners a corporation can have. Most states allow shareholders to include people, LLCs, other corporations, and even foreign entities. The majority of states also allow an individual owner to form a single shareholder corporation.
Federal Taxes For Corporations
For tax purposes, there are three types of corporations — C corporations, S corporations, and nonprofit corporations.
The IRS recognizes a C corporation as a separate taxpaying entity. The business profits are taxed as “personal income” of the corporation and then distributed to its shareholders. Then the distributions are taxed again as the shareholders’ income on their personal taxes.
A S corporation avoids double taxation on corporate income by passing through to its shareholders the company’s income, losses, deductions, and credits for federal tax purposes. Shareholders report the company’s income and losses on their personal tax returns and the IRS assesses their taxes at their individual income tax rates.
A nonprofit corporation is created to do charity, education, religious, literary, or scientific work. Nonprofits may file with the IRS to receive a federal tax exemption, which means they don’t have to pay federal income taxes on any of the profits that the corporation makes (as long as that income is made in furtherance of the nonprofit’s mission).
Benefits of Choosing a Corporation
- Limited personal liability for business debts, meaning your personal assets generally cannot be seized by business creditors.
- Easier to secure credit, funding, and financing.
- Easy to transfer business to new owners.
- Profits and losses belong to the corporation.
- Presents a more professional image to potential clients or customers.
Disadvantages of Choosing a Corporation
- Expensive to form and operate.
- Requires complex paperwork to establish.
- Must file a separate tax return for the business.
- Subject to more regulations and record-keeping requirements.
- More complicated structure requiring shareholders and a board of directors.
- C corporations are subject to double taxation.
Limited Liability Company
Like corporations, a Limited Liability Company (LLC) is a business structure that is created by state statute. However, unlike corporations, not all states recognize LLCs, though most do. Each state that recognizes LLCs has its own statute and requirements for forming a LLC, so you will need to check the requirements in the state in which you are registering before starting a LLC.
Generally, the owners of a LLC are called members, and there is generally no maximum number of owners a LLC can have. Like corporations, most states allow members to include people, corporations, other LLCs, and even foreign entities. The majority of states also allow an individual owner to form a single-member LLC.
Federal Taxes for LLCs
The way an LLC is treated for federal tax purposes depends on both the number of members and the elections that the members make.
By default, the IRS will treat single-member LLCs as sole proprietorships for tax purposes. This means that the IRS would consider any income as the owner’s income, and the income from the LLC would be included in the owner’s personal tax return. The LLC itself will be treated as a “disregarded entity” and will not be subject to any federal income taxes. Similarly, the default tax classification for LLCs with at least two members is a partnership.
However, LLCs can file Form 8832 with the IRS and elect to be treated as a corporation for tax purposes. If a LLC decides to be treated as a corporation for tax purposes, they must decide whether to be treated as a C corporation, an S corporation, or a nonprofit corporation when taxed by the IRS.
Benefits of Choosing an LLC
- Limited personal liability for business debts, meaning your personal assets generally cannot be seized.
- Fewer regulations and record-keeping requirements than for corporations.
- The LLC structure is less complicated than a corporation — no board of directors required.
- Allows flexibility in how profits can be distributed.
- Can avoid double taxation of company profits.
Disadvantages of Choosing an LLC
- More expensive to start an LLC than a sole partnership, and in some states, a corporation.
- Operating agreements can be complex and need to cover all contingencies.
- Checks must be deposited into a separate business account.
- Can be more difficult to find investors due to the effect of pass-through taxation on an owner’s personal taxes.
How to Pick the Best Legal Structure for Your Business
As you can see, there are many considerations to account for when deciding which legal structure you should use to establish your new business. It’s important to reflect on factors such as:
- Your goals for your business.
- Your willingness to expose your personal assets.
- Your need for outside funding.
- How much control you want in the operation of your business.
- What you want the day-to-day operations of your business to look like.
- What is most advantageous for you taxwise.
Deciding what legal structure to use for your business is an important decision and you should not make it lightly. Make sure that you give yourself enough time to consider all of the pros and cons of each structure before deciding which structure is best-suited to help your new business meet its goals.
Attorney Kristy Cook, founder of the bi-coastal Mod Law Firm, serves for-profit and non-profit businesses in both North Carolina and Oregon with passion and dedication. As a mission-oriented person, nothing fulfills Kristy more than providing legal solutions for purpose-driven businesses, no matter their size. We invite you to schedule a consultation today!