Choosing the right legal structure for your business is one of the most important decisions you’ll make. It affects how your company is taxed as well as the level of liability protection.
Let’s take a look at the common legal structures you might consider for your small business:
When you are the sole owner of your business and don’t elect a specific formal business structure, you will by default be a sole proprietor. Many home businesses operate this way. As a sole proprietor, you as an individual are your business. From an income tax standpoint, your business profits and losses flow through to your personal income tax return. One potential downside of a sole proprietorship is the lack of liability protection it provides. If someone sues your business and your company doesn’t have funds to pay the legal fees or creditors, your personal assets are at risk. The upside to operating as a sole proprietor? Simplicity and cost effectiveness. Aside from needing to file a DBA (Doing Business As) if you’re using a fictitious name for your business and securing a business license (if required for your type of business), you avoid the formation paperwork, costs, and ongoing compliance that come with other legal structures.
When your business has multiple owners and the owners don’t elect a specific formal business structure, the business will by default be classified as a general partnership. As with a sole proprietorship, a general partnership’s profits and losses flow through to the owners’ personal income tax returns. And as with sole proprietorship, owners’ personal assets are not protected from legal action brought against the business.
Corporation (C Corp)
C Corporations operate as separate legal entities from their owners and offer limited liability protection to their shareholders, directors, officers, and employees. C Corps are subject to two levels of taxation: one at the corporate level and another at the shareholder level. The C Corp structure offers the advantage of raising funds through sale of stock (either privately or through the public markets) to an unlimited number of shareholders. Delaware C Corps are the preferred entity of venture capitalists and other sophisticated investors. The startup costs are higher with a corporation and you can expect more compliance formality and less tax flexibility than with LLCs and S Corporations.
S Corporation (S Corp)
S Corp is not a type of corporation but a type of tax status available for eligible C Corps. S Corps are identical to all other corporations except for their tax status. S Corp taxation is popular for many small business owners because it offers one level of tax at the shareholder level and some relief from the self-employment tax burden of owners of LLCs that have not elected to be taxed as S Corps, sole proprietorships and partnerships. Only an owner’s reasonable wages/salaries are subject to self-employment (FICA) tax while profits distributions to the shareholders are not. Shareholders’ distributions are assessed tax at the shareholders’ individual income tax rates. Like C Corps, S Corps may raise capital though sale of stock to shareholders, although limitations apply.
Single-Member Limited Liability Company
This structure, which is available to businesses with one owner, provides the limited liability advantages of a corporation and the flexibility of a sole proprietorship. It reduces owner liability without the formation complexities and compliance requirements that come with corporate structures. Typically, taxes are handled as for sole proprietorships (pass-through taxation to personal income tax returns) or you can opt for C Corporation or S Corporation tax treatment. With “LLC” at the end of a business name, customers might perceive a company as more credible than a sole proprietorship.
Multi-Member Limited Liability Company
When a limited liability company has multiple owners, it’s classified as a multi-member LLC. By default, a multi-member LLC is taxed as a partnership, but owners can instead elect for their business to receive S or C Corporation tax treatment.
Which Legal Structure Is Right For Your Small Business?
According to attorney and SCORE mentor Chris Dargie, entrepreneurs should begin the process of determining the best legal structure by considering three core questions:
- What is the company’s purpose and business plan?
- Who are the owners and what is their level of involvement in the business?
- Will the company require outside capital, and if so, what type? (For example, to obtain venture capital, you would likely need to form, or convert to, a Delaware C Corporation before venture capitalists would consider investing in your business.)
Pitfalls To Avoid
While it is possible to change a business’s entity type at any time, doing so midstream can involve expensive tax consequences. Therefore, tax is a crucial consideration when selecting an entity.
The most common mistake Dargie sees with small businesses is the failure of sole proprietorships to convert to at least LLCs for liability protection. “There is rarely a reason for a single-owner business to operate as a sole proprietorship,” said Dargie. “Single-member LLCs are simple and cheap to form and maintain, and they offer liability protection for the owner at a cost that is much cheaper than commercial insurance. They’re really a no-brainer.”
Another common mistake Dargie sees is multi-member LLCs that lack basic operating agreements. “Most entrepreneurs understand that an entity offering limited liability protection to the owners is desirable, and the default entity type these days is the LLC,” explained Dargie. “However, LLCs with multiple owners present serious traps for the unwary. Anyone starting a business with others and intending to form an LLC should get some basic legal advice about the risks.”
Something else that Dargie has seen adversely affect business owners is when they’ve unknowingly created a general partnership. As an example, let’s say you’ve started a cleaning company and asked a friend to help you clean a few homes. Rather than putting your friend on payroll and compensating via an hourly wage, you instead agree to share a portion of the profits you make on the jobs he helps you with. By doing so, you’ve potentially made him a partner, and you’re potentially legally obligated to follow the legal and accounting requirements of a partnership.
Other common mistakes Dargie sees include commingling personal funds with business funds and the failure of companies to maintain adequate company records. “Owners should always treat their business entities as separate from themselves. Failure to do that can result in loss of liability protection and serious tax headaches,” shared Dargie.
With so much affected by the legal structure you choose, you need to do your homework and be as informed as possible. Be sure to consult with both legal and accounting professionals so you’re fully aware of how each structure will impact your taxes, liability risks, and ongoing compliance obligations. As you’re working through the process, remember that our SCORE mentors are here as a resource to direct you to trusted and reputable professionals in your area who can guide you in making this important decision.
Chris Dargie is a full-time attorney / director / shareholder at Perkins Thompson in Portland, Maine. He started volunteering with SCORE in January of 2014.
Please note that this article is for informational purposes only and should not be considered a substitute for professional legal or accounting advice.