Deciding to become an entrepreneur is exciting. Setting up a business? Not so much. A lot goes into establishing a company, whether you’re a solo founder or a partner with dozens of employees. 

Different business structures come with various benefits. But if you choose the wrong one, it could hurt you in the long run (legally and financially). 

So put in the work to learn which business legal structure is suitable for your new company, and get familiar with the pros and cons of each option. 

What is a business legal structure?

A business legal structure, or business entity, is a classification of a company and how it operates. It also regulates your federal and state tax obligations.

There are four primary categories:

  1. Sole proprietorship
  2. Partnership
  3. Limited liability company (LLC)
  4. Corporation

Planning to run a business yourself? Or maybe you want to bring aboard a co-founder or two. Sometimes, a partnership may seem ideal initially, but you later find a multi-member LLC a better choice. It can be expensive and time-consuming to alter your business structure down the road, so keep your future plans in mind when choosing how to incorporate now. 

Four types of business structures

1. Sole proprietorship

A sole proprietorship is the easiest business structure to start. In fact, there’s no setup involved — if you’re a solopreneur, you’re automatically considered a sole proprietor. 

This means you own and operate the business as one individual — there’s no difference between the owner and the business. You file taxes under your legal name or a fictitious name you registered with the Division of Corporations. 

On the upside, you’re in complete control over your business since there are no partners or shareholders. 

The downside: If a customer sues you, you’re responsible for the liabilities incurred — and your personal assets are up for grabs. If you own a home, vehicle, or checking account, the courts can seize them to repay business debts and lawsuits. 

The only way around this is to purchase business insurance and include liability waivers in contracts. Another option is to transfer or share personal assets with someone else. 

For taxes, sole proprietors must pay federal and state income taxes, depending on where they operate. Some states don’t charge income taxes for sole proprietorships, such as Florida. 

It’s free to establish a sole proprietorship, but if you register a Doing Business As (DBA) name, you’ll pay between $10 to $100. 

Examples of sole proprietors include freelancers, gig workers, and small business owners like writers, web developers, hair stylists, and online store owners. 

2. Partnership

A partnership is like a sole proprietorship, except two or more people own it. There are two types of business partnerships:

  1. Limited liability partnerships (LLP)
  2. Limited partnerships (LP)

In an LLP legal business structure, each partner has limited liability. The partners’ personal assets are off-limits in litigation and for debt repayment. Plus, partners are protected from the actions of other partners. 

So if one co-owner gets sued for misconduct, the other partners aren’t responsible for the costs that incur. 

An LP is a little different — one or more general partners (GPs) have unlimited liability, and the other owners have limited liability. The differences between LPs and GPs:

  • GP is part owner and has specialized knowledge and skills in the industry, so they take part in business operations (e.g., doctors or lawyers in a practice)
  • GP’s personal assets are susceptible to seizure to repay business debts (there’s no limit to how much the GP can be liable to repay)
  • GP has authority to act on the company’s behalf, without permission or knowledge of the LPs
  • LPs are only liable for debt up to the amount they’ve invested
  • LPs can make business decisions as long as it’s in line with what’s in the partnership contract

All partners decide the voting power LPs will have, which can be restricted to certain areas. For example, a LP may have 20% voting power because they invested 20% of the capital in the company, and can only vote on matters revolving around equipment purchases and acquisitions.

The partnership agreement details the roles and rights of each partner to prevent future conflicts, and is critical to have before establishing the business.

It should outline things like:

  • Profit and loss sharing: What percentage each partner receive in profits and losses — equal or based on the contributions/investments of each partner
  • Dissolution terms: What happens if one or more partners decide to leave the business voluntarily or involuntarily (e.g., death, incapacitation, breach of agreement, etc.)
  • Management rights and responsibilities: What each owner will control in the business and their duties (e.g., finances, operations, etc.)
  • Capital contributions: How much each owner will invest in the company to launch and maintain it
  • Dispute resolution: How the partners will resolve problems (e.g., mediation or other process)

This isn’t an all-inclusive list, but provides an idea of what most partnership agreements cover. 

Note that partnerships are tax-reporting entities (not tax-paying). It’s required to file Form 1065 annually to provide information to the IRS about business profit and losses. However, the business doesn't pay taxes to the government. 

Instead, profits and losses pass through to the owners. Each owner must fill out a tax return and include details about their percentage share of the profit (based on the partnership agreement). They then pay taxes on their portion of the profits or report a loss. 

Partnerships aren’t difficult to form, but require detailed agreements that are best done with the help of an attorney.

The cost to start a partnership depends on several factors, such as the number of partners, the state in which the business is located, how extensive the agreement is, and whether the partnership is an LP or LLP. It can cost a few hundred dollars to over a thousand dollars. For instance, registering an LLP in Florida is $1,061 and — and around $200 for an LP in Delaware.

Plus, there may be an annual renewal fee as high as $820. 

Examples of partnerships include medical, legal, and dental practices. 

3. Limited liability company

A limited liability company, or LLC, is a mix of corporate, sole proprietorship, and partnership legal business structures. It provides liability protection to safeguard your personal possessions from business debts. 

LLCs can have one or more members, like a partnership. But some states require the business to dissolve when someone leaves the company. You can then re-form the company under the same or a different business structure. If you plan to sell the company one day, include a clause in the agreement about buying, selling, and transferring ownership of the LLC. 

An LLC is a tax-reporting entity and must file an informational tax return. However, it pays no taxes to the IRS as its business income passes through the company to the LLC members. Each member files an individual tax return to report their share of profits or losses. This can prevent double taxation (paying corporate taxes on the profits, while also paying personal income tax on your owner’s salary). 

However, since LLC members are self-employed, they pay self-employment tax contributions for Medicare and Social Security. If you’re the only LLC member, you can report business expenses using Form 1040 Schedule C, E, or F. 

If there are two or more LLC members, each must file a partnership return using Form 1065. Remember that each LLC member’s profit share is taxable income, including undistributed profits. 

Be careful — you may be required to pay tax on every dollar over $250k for undistributed earnings to shareholders. 

The cost to form an LLC depends on the state, but can range between $100 and $800. You must also have articles of organization (certification of formation) before establishing the business.  

Some states require an LLC operating agreement outlining:

  • Profit and loss sharing
  • Buy-sell provisions
  • Member voting power
  • Ownership interest per member
  • Rights and responsibilities of each member

LLC is an ideal business structure for medium-risk companies. It separates your business and personal finances, since you’ll need a separate bank account to run your business (this holds true for all business structures except for sole proprietorship). 

Examples of LLCs include real estate companies, law firms, accounting firms, and consulting businesses. 

4. Corporation

A corporation, or C-corp, is independent of the people who own and run it (shareholders). As a shareholder, you own portions (shares) of the corporation, giving you partial ownership rights.

The more shares you own, the more voting power you have. It also allows you to receive dividends (share of the profits after taxes). Dividends are taxable, but not until they’re distributed to the shareholder. 

Note that a corporation doesn’t shut down if the owner(s) die. Instead, the shares pass on to whomever is listed in the formal governing documents. If this isn’t predetermined, then it’ll go to the heirs of the deceased shareholder. 

A corporation is considered a separate legal person — it has its own assets and liabilities. Therefore, it can do things separate from its owners, such as enter into contracts, sue and be sued, and pay taxes. Its structure even protects shareholders’ personal assets from business liabilities and debts.

It’s similar to a partnership, except corporations are owned by shareholders who elect directors to oversee the company. The board of directors then hires managers to run the business. So it’s an attractive option for investors who want to earn from the company, but don’t want to work “in” the business. 

There are two types of corporations: 

  1. C corporation 
  2. S corporation 

Both are taxed differently.

A C-corp is its own entity and must file a tax return using Form 1120. It must pay corporate income tax for all corporate profits. Then shareholders pay taxes on income from profits distributed to them by the corporation. This results in double taxation

An S-corp is different — the income, losses, deductions, and credit pass to the shareholders. The company reports income and losses  (using Form 1120S). Then the shareholders report and pay taxes on corporate income and losses when they file individual tax returns. This prevents double taxation. 

It’s common for sole proprietors and LLC businesses to elect to be taxed as S- corporations to save on taxes. But it’s only worth it if you earn at least $75k a year.  

For example, your business generates $100k in earnings per year — and instead of the entire amount passing onto you like a regular LLC member, you could split the $100k by paying yourself a salary of $50k and taking the rest as dividends. You’ll pay $7,650 in self-employment tax (or 15.3%) for your pass-through income — not the dividends — saving you $7,650 compared with getting all $100k as a pass-through. 

Although forming a corporation is the most complex, it’s affordable, costing between $50 and $200. 

Examples of corporations include social media companies, software companies, and grocery chains.

Selecting the optimal business structure is a big decision — re-forming a company is stressful and expensive, so it’s better to get it right the first time. Consider your long-term plans, and consult with an attorney to learn the best options based on your new business’s industry, location, and number of owners/partners.

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Originally published Jul 27, 2022 8:00:00 AM, updated August 04 2022

Topics:

Startups Entrepreneurship