Published on July 26th, 2023
On average, 4.4 million new businesses are started each year in the US.
Starting a business can be a great opportunity, but it isn’t easy. There are various challenges you’ll face and decisions you’ll need to make.
One of the first things you need to think about is the legal structure of your business.
Now you might be asking “What is the legal structure of a business?”. In this guide, we’ll cover everything you need to know. Keep reading for more.
What Is The Legal Structure Of A Business?
Your business legal structure is one of the first things you need to decide about your business, as it will affect many other aspects of it.
There are four main structures available, and each has benefits and drawbacks. You need to understand how each business structure works so you can determine which is best for the company you want to build.
A sole proprietorship is a business that’s owned and operated by a single individual.
This individual and the business are considered the same legal entity. This is a very common choice for a small business that someone starts alone.
The business itself doesn’t need to file a tax return. The income is instead reported on the owner’s personal tax return.
It’s easier to form a sole proprietorship than other business structure types. It also tends to be the cheapest option and gives the owner complete control over the business.
When forming a business this way, the owner will have full liability for the business. This creates more risk, so it’s important to have suitable insurance and sound contracts.
A sole proprietorship also can’t hire employees, so if you want to take on additional staff, this option may not be suitable.
A general partnership can be formed between two or more people. This makes them a bit harder to form than sole proprietorships, but they’re the easiest structure that involves more than one person.
The terms of a partnership have formal rules regarding ownership percentages, profit/loss sharing, dissolution terms, management rights, and more. Both partners are jointly liable for the business.
A partnership needs to file an annual information return to report any income and losses. It doesn’t, however, need to pay federal income tax.
The ownership percentages determine how profits and losses are passed through to the owners. Each partner must then pays taxes depending on their share.
While these are typically easy to form, it can be a good idea to work with an alternative legal service provider. This will help ensure the partnership agreement is fair and favors the best interests of all parties.
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Limited Liability Company (LLC)
An LLC is like a combination of a sole proprietorship, a general partnership, and a corporation.
There can be multiple owners (called members), and these can be individuals, corporations, foreign entities, and other LLCs. In most states, single-member LLCs are also an option.
The business income of an LLC passes through to the members. They then report their own profits/losses on their individual income tax returns. The LLC entity only needs to file an informational tax return.
One of the main benefits is that members are protected from personal liability when it comes to things like claims and business debts.
This means that while business assets are at risk, the personal assets of members aren’t.
This may not be the case if a member uses their personal account for business purposes, so it’s important to keep things separate.
Forming an LLC is more complicated and expensive. It’s good practice to have operating agreements, although this isn’t required in all states. An operating agreement can include rules relating to things like:
- Member voting power
- Profit and loss allocation
- Member rights and responsibilities
- Management structure
You can have an unlimited number of members with an LLC. It’s worth noting that there can be additional state taxes, so you should look into the conditions for your state first.
Corporations (C-Corp And S-Corp)
Corporations are the most complex structure available. They’re operated by shareholders who are separate legal entities from the business. This structure is more suitable for larger companies with a lot of employees.
A corporation is known as “immortal” as it won’t terminate upon the deaths of the shareholders.
Shareholders aren’t liable for company debts or obligations – so long as they don’t use personal accounts for business purposes.
Due to the complexity of creating and operating a corporation, it’s highly recommended to work with a legal service provider throughout the process. Decision-making can also take a long time due to the high level of governance.
A C-Corp is its own entity for income tax purposes. Any profits are subject to corporate income tax, and shareholders need to pay personal income tax on the profits they receive from the company. This is known as “double taxation.”
S-Corps can pass income, losses, credit, and deductions through to shareholders for tax purposes.
The company still needs to report these, and the shareholders must report the company’s income and losses on their personal tax returns. This avoids double taxation
The Right Legal Structure For Your Business
You no longer need to ask “What is the legal structure of a business?”, but you might still be trying to decide which is best for your company.
You need to consider factors like how many people will own it, the risk exposure you’re open to, and how you want to deal with taxes.
For more business articles, check out some of our other blog posts.
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