Learning & Insights
Determining the legal structure of your company
Should you set up your business as a sole proprietorship, partnership, or corporation? Each has its own advantages and disadvantages based on your situation.
First things first
As you begin the process of deciding on the best legal structure for your business, keep the following questions in mind:
- What is the essential purpose of my business?
- What are the legal advantages or disadvantages of the different legal structures for my particular business?
- How much risk will I (and any investors) be incurring with regard to taxes, debts and other expenses?
- Is there a realistic opportunity for me to raise more capital?
- What is my contingency plan in the event of unforeseen circumstances?
Consider hiring a legal professional
Chances are, as the owner of a small business, you have more than enough on your plate already. Instead of attempting to navigate this legal landscape on your own, consider seeking professional advice from a CPA or an attorney. They can help guide you through the many technical and legal issues that relate to any of the relevant legal structures for your business.
The amount of time you'll save—not to mention the peace of mind you'll gain—can far outweigh the expense of hiring a professional. Remember, too, that laws, regulations and requirements are constantly changing, and a CPA or an attorney can help you keep abreast of the changes and advise you as to any necessary adjustments.
The sole proprietorship
Easily the most popular of the business structures, the sole proprietorship is also the easiest to establish. All you really need is a marketable concept, a name for your business and any applicable licenses.
Other than that, no formal action is required on your part to get your business up and running, and you probably won't have to hire an accounting or legal professional to set up your sole proprietorship.
As the owner of a sole proprietorship, you'll have what is known as "single-entity status;" that is, you and the business are seen as one and the same in the eyes of the law.
Advantages of a sole proprietorship
- Easy to set up – You'll have very little paperwork to deal with.
- Economical – Normally, you'll simply pay a nominal business license fee and possibly a business tax. Your city or county government office can provide you with details.
- Easy to dissolve – You have the authority to dissolve your business at any time. No formal paperwork is required, and no legal waiting period applies.
- Autonomy – As the sole owner, you'll get to make all the business decisions, shift funds in and out of your accounts and reap all the profits. The potential downside, of course, is that any losses also would be your own (although you may be able to deduct net losses on your tax return).
Disadvantages of a sole proprietorship
- Personal liability – As the sole proprietor, you'd be responsible for all business debt. Recall that in the eyes of the law, you and your business are one and the same. As such, your business and personal assets are both at risk if you're unable to pay your business debts.
- Limited capital-raising ability – It may be difficult for you to obtain business loans to help grow your business until you've established a good credit rating.
- Limited personal resources – As the sole owner, there's only so much you can do, even if you work nights and weekends. Many small business owners find it challenging to find the time to develop new business in addition to handling their current business needs.
- Limited tax savings – The tax benefits that corporations receive for providing benefits such as medical insurance, group-term life insurance and long-term disability coverage are not available to sole proprietorships.
- No succession option – As a result of your single-entity status, in the event of your death, your business would also cease to exist.
The partnership structure shares a number of similarities with the sole proprietorship. For example, both entail unlimited liability for the owners. A partnership, however, gives you the opportunity to share the work, decision-making, financial pressure, and all the risks and rewards that come with owning a business.
You can choose from different types of partnerships; your choice will depend on the level of your partners' interest and expertise. For example, general partners typically share in the managing, financing and liability of the company. Limited partners, on the other hand, take a less active role on the management side, and tend to focus on their investment in the business and its attendant liability.
Partnerships may or may not be divided up equally—it's quite common for one person to assume majority ownership in a partnership.
Advantages of a partnership
- Easy to set up – As with the sole proprietorship, the partnership requires no formal paperwork, and no legal waiting period applies.
- Complementary skills – With the right partners working together in sync, your business could become one in which the whole is greater than the sum of its parts.
- More potential for growth – Lending institutions tend to favor partnerships over sole proprietorships because if something should happen to one partner, the others would be available to provide financial or operational coverage.
- Financial rewards – Partners get a return on their investments of time, energy and money by directly sharing in the profits.
- Tax advantages – Generally speaking, a partnership pays no income tax. Partners are expected, instead, to report their share of losses or gains on their personal tax returns.
Disadvantages of a partnership
- Personal liability – As with sole proprietorships, each partner has personal liability for any debts, taxes or other claims against the partnership.
- Conditional succession option – Partnerships usually terminate upon the death of one of the partners unless a specific agreement has been drawn up in advance to provide an alternative.
- Compromised control – Unless specified by written agreement, each partner has the authority to make decisions—financial or otherwise—that may or may not be in the best interest of the business.
As the most complex and formalized type of business structure, the corporation is more difficult and expensive to set up, and it requires more paperwork.
Corporations are legal entities that are organized according to state and federal statutes. Ownership consists of shares of stock, and business activities are defined by a charter, which details the powers and limitations of the business.
Corporations must observe certain guidelines and operating rules, including keeping accurate records, holding regular meetings for corporate directors and maintaining a financially independent account for the corporation. Corporations intending to operate in multiple states must comply with federal interstate commerce laws as well as individual state laws.
An "S corporation" differs from a traditional corporation in one important way: Its members have chosen to be treated, in essence, like a partnership for federal income tax purposes. Taxable income, deductions, losses and credits are passed through to the stockholders. Therefore, S corporations don't pay taxes at the corporate level.
Carefully consider your decision to obtain S corporation status, and seek the counsel of a tax professional, as this is a very technical and complex area of the law.
Advantages of a corporation
- Limited liability – Stockholders in a corporation generally aren't personally liable for claims against the corporation and are liable only for their investment in the stock.
- Succession options – The business is unaffected by the death or transfer of shares of any of its owners. Suppliers, creditors—even customers—often appreciate this kind of continuity.
- Capital-raising ability — Corporations, by their very nature, are in a much better position to raise capital because they have a large investor pool to draw from.
Disadvantages of a corporation
- More expensive to set up – Multiple forms, such as those for permits and articles of incorporation, must be filed, and the associated legal fees can add up.
- Record-keeping requirements – State and federal governments have continual filing schedules for various forms associated with corporations, making it essential to stay on top of your record keeping.
- Tax liability – Unless the company successfully secures S corporation status, owners may be taxed on dividends and the profits of the business.
Limited liability company
A limited liability company (LLC) can be formed by one or more owners. Similar to a partnership, profits and losses of the LLC are generally passed through the company to its owners and are taxed based on the owner's adjusted gross income. But much like corporations, LLC owners are protected from the liability and debts of the company.
Advantages of an LLC
- Liability protection – Owners cannot be held responsible for their LLC's debts, providing the owners' personal assets (such as automobiles, residences and bank accounts) are kept separate from those of the business.
- Simple set-up – You can establish an LLC with a minimal amount of paperwork and fees.
- Autonomy and flexibility — Owners and managers are authorized to make daily operational decisions.
Disadvantages of an LLC
- Liability limitations – Owners may be held responsible for their LLCs debts if the owners' personal assets are not kept separate from those of the business, or if one or more owners have engaged in fraudulent activity.
- Self-employment tax liability – Owners would be responsible for paying their own Medicare and Social Security taxes unless alternate tax arrangements are made under an S corporation structure.
- Change of ownership — The LLC must be dissolved in the event of the resignation, bankruptcy or death of one or more owners.
Your choice is important—but not set in stone
Selecting a business structure is one of the first—and most important—decisions you'll have to make when starting your business. You'll want to take your time, do your research and weigh all of the advantages and disadvantages before making your choice.
Not sure what type of business structure is right for you? Many businesses start off as a sole proprietorship, and evolve into another business structure as their business grows.