One of the most important early decisions a business owner can make is the legal structure of the company. The business structure influences what taxes the company must pay, as well as how the organization functions day to day.
The business structure, or legal entity, also determines the owner’s exposure to monetary and legal risk at the local, state and federal levels.
There are many ways to structure a business, all of which have benefits and potential drawbacks. Not every business structure is available for use in every U.S. state. Tax liability, required legal forms and regulations differ from state to state.
It is vital for anyone who is considering starting a business to understand why and how to choose a certain business structure. A business consultant or business attorney can provide guidance, but it is the responsibility of the owner to make the final decision.
Business Structure Types
The time to determine the legal structure of a new company is during early planning. The U.S. Small Business Administration (SBA) recommends selecting the business structure as the second step in launching a new company, right after picking a geographic location.
However, before picking a legal structure, it is necessary to establish a few parameters and goals. These include:
- Number of employees
- Scope of business
- Anticipated revenue and expenses
- Sources of start-up funds
- Sales goals
Some business structures require a great deal of paperwork and licensing, while some are assumed the instant a business transaction is conducted for the first time. Below are the standard legal structures available to business owners in the U.S.
This structure encompasses self-owned, self-financed and self-run companies. An example of a sole proprietorship is a website-based company owned by an individual who designs, creates, sells and ships homemade holiday ornaments.
The Internal Revenue Service (IRS) defines a sole proprietor as “someone who owns an unincorporated business himself or herself.”
The main benefit of a sole proprietorship is that it is simple to form. A company is automatically a sole proprietorship once business has been conducted. It also is relatively easy to maintain, because no business registration is necessary in some cases.
The biggest potential drawback of a sole proprietorship is that the owner is exposed to personal liability. The business entity and the individual are, for legal purposes, the same.
That means any debt, obligations and tax liability fall on the owner, which means his or her personal belongings potentially are at risk. Taxes owed on net business profits also must be paid as personal income taxes by the owner.
Some business owners launch as sole proprietors to test a concept, then establish a different business structure as the company gains success.
A partnership is a simple business form in which the ownership is shared by two or more people.
The IRS definition of this business structure is “the relationship existing between two or more persons who join to carry on a trade or a business.” An example of a partnership is a group of investors who ban together to purchase a professional sports franchise.
Like a sole proprietorship, a partnership does not require the owners to file registration forms or pay fees. However, most partnerships are established in writing, with clearly defined roles and responsibilities for the partners. Also like a sole proprietorship, the owners in a partnership must pay personal income taxes on business income.
There are two main types of partnerships: general and limited. There also is a third category, less-commonly used: the joint venture.
In a general partnership, management duties, funding and profits are shared equally. In a limited partnership, general partners run the business while limited partners provide investment money. A joint venture is a general partnership that is formed on a temporary basis to complete a single project.
The dissolution of a partnership is governed by local, state and federal rules – even if the company does not have its own unique set of rules. In general, a partnership can’t be fully terminated until all obligations are discharged.
Limited Liability Company
A limited liability company (LLC) is a bridge of sorts between the easily established but relatively high-risk sole proprietorship or partnership and the much more regulated corporation. LLCs are governed through state statutes, which means it is vital to understand the regulations of your state when considering whether to establish a business as an LLC.
The IRS defines an LLC as “either a corporation, partnership or as part of the LLC’s owner’s tax return (a ‘disregarded entity’). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation.”
While most LLCs are small businesses, the structure can be used for any sized privately owned company. Car manufacturer Chrysler and online vendor Amazon are examples of large companies established as LLCs.
An LLC is more expensive to establish than a sole proprietorship and more complex to manage, but it provides more protection from liability than sole proprietorships and partnerships. In most cases, the assets of the company are at risk, while the personal assets of the members of the LLC are not as exposed.
When an LLC is established, its owners determine whether the company is taxed as a partnership or a corporation.
A corporation is a legal entity set up by prospective shareholders to trade or do business. There are several types of corporations – C corporations, S corporations, B corporations, close corporations, nonprofit corporations and more.
The SBA defines a C corporation as a “legal entity that is separate from its owners. Corporations can make a profit, be taxed, and can be held legally liable.” Corporations sell stock and pay dividends to shareholders. A board of directors governs the corporation, and officers (chief executive, chief financial, chief operating, etc.) are charged with operating the business.
The Coca-Cola Company is an example of a well-known and massive corporation.
The owners of a corporation are shielded from paying taxes on the company’s revenues, in most cases. Corporations also enjoy tax benefits such as deductions for business expenses and incentives to operate in certain cities or regions.
It is far more expensive to establish a company as a corporation. Because a corporation can take advantage of many tax breaks, they are subject to regulation and scrutiny. Therefore, accounting professionals are either hired on staff or kept on retainer to help keep the business in compliance.
A cooperative, or co-op, is defined by the SBA as “a business or organization owned by and operated for the benefit of those using its services.” The members, or user-owners, split all profits and share expenses, making decisions democratically.
An example of a cooperative in the United States is the milk co-op, Dairy Farmers of America, Inc. This group brings together nearly 15,000 dairy producers in the U.S., who own the co-op together and use it to market and sell milk products around the country and the world.
What Business Structure is Right for Your Company?
The time to determine the legal structure for your new business is early, as the business plan is being formulated. Moving forward without understanding how the company will be structured – who will make the decisions, who is responsible for paying expenses, how taxes will be determined, etc. – is a good way to go out of business quickly.
A business consultant or attorney can provide guidance and education about the regulations for legal structures in your state. But that’s only the start: The business structure you choose must give you the flexibility you need to grow, the security you need to shield yourself from personal liability and the efficiency you need to make sure you meet your obligations.
A thorough grounding in the basics of business is a good beginning, but a 100% online MBA from Jacksonville University’s Davis College of Business can help give you the detailed insight you need to choose the right business structure for your company – or to become a business consultant who helps others launch and grow companies.