How to Choose the Best Legal Structure for Your Business in the US
When creating a new business, choosing the most suitable legal structure is one of the biggest decisions you will need to make.
It will have an impact on the organizational structure, liability and taxes.
This article will cover the options for different business structures and how to choose the right one to meet your needs.
Regulations and requirements will vary between states, so it is wise to check your obligations based on your business location.
The legal structure of a business refers to the kind of entity the business is considered by law.
The most important considerations include how much liability protection is offered and the payment of taxes.
Each legal entity impacts different aspects of the business.
The different structures affect:
- Income tax
- Paperwork and records
- Organizational hierarchy
- Raising investment capital
- Establishment and ongoing expenses
These aspects should be considered when choosing which legal structure to operate under and will be covered in this article.
Sole proprietorship businesses are simple to create and manage. Legally, the business and the owner are treated as the same entity.
This is the most common type of business structure in the US. Sole owners can take the option to convert the business to a limited liability company (LLC) or corporation further down the line.
The main advantage of a sole proprietorship is being your own boss. Full control of the business resides with the owner.
This structure is suited to self-employed smaller businesses and low-risk industries. Low-litigation industries such as freelance writing or graphic design would be a good fit.
Initial expenses will be low if the business can be run from home or online.
Banks are reluctant to make business loans to sole proprietors. Take this into account when creating your initial business plan.
- Business can be dissolved easily
- Net business loss can be deducted from personal income taxes
- No need to register with the state
- Personal liability is higher for business debts
- Income tax is paid on all net profits of the business
- Difficult to obtain outside investment
LLCs combine the best features of corporations and partnerships. They are popular with entrepreneurs due to their personal liability protection.
It is common for sole proprietors to restructure their business as an LLC as a result of rapid expansion.
LLCs can have one or more owners. There is flexibility around the management setup, so the business structure can be designed by members.
Due to the limited liability protections, if the business is sued, protection is provided for any personal assets.
Running a company as an LLC is common for law firms and the financial sector. It is a good choice for medium- to high-risk businesses.
- Can be taxed as a corporation or a partnership
- Limited liability for the owners
- Less paperwork and documentation than corporations
- More costly to establish than partnerships or sole proprietorships
- Profits and losses are recorded on personal tax returns
Corporations are the most complex structure and can be expensive to establish. A corporation is created by filing articles of incorporation.
This process will involve qualifying for a C or an S corporation, which affects what taxes the business is subject to.
Corporations are regarded as separate entities in law. They can have one or more owners who are called shareholders.
Corporations can be traded publicly on a stock exchange. This means there is the potential to create a large amount of capital.
They are subject to several regulations to ensure they are managed correctly. Professional accountancy will be required.
There are different types of corporations:
- C corporations – Allow an unlimited number of investors, so are popular for large businesses like Amazon. It is easier to raise investments for a C corporation and there are no restrictions on ownership.
- S corporations – Generally suitable for small businesses wanting to avoid incurring double taxation. However, they are unable to have more than 100 shareholders.
- B corporations – Also known as ‘benefit corporations’. Their goal is to provide a benefit to society by promoting environmental or social change alongside profit.
- Can generate capital easily by selling stock and attracting investment
- Personal assets are protected; only business assets are affected if sued
- Eligible for certain tax deductions
- Strict formalities and complex regulations to follow
- Expensive to establish
- Detailed records and minutes of meetings must be kept
Although similar to a sole proprietorship, this structure involves more than one business owner. Parties take an equal role in this partnership, so it can be straightforward to establish and run.
Responsibilities for the management of the business as well as liabilities are shared. It is a popular option for family businesses such as restaurants or stores.
- Straightforward to set up and maintain
- Does not require state registration
- Share of net business losses can be reported on personal income tax returns
- All owners are personally and jointly liable for business debts
- Personal income taxes are paid for business net profits
- Partnership agreement needed to manage disputes
Limited partnerships are often used for the real estate industry. Investors are only liable for the amount they invest, so can be easy to attract.
With this structure, some partners may provide capital and share profits but do not take an active role in running the business.
A partnership agreement will outline the extent of each partner's control. Creating the paperwork for this type of legal structure can be complex.
- Limited liability for all debts and business decisions
- Limited partners can leave the business without dissolving the limited partnership
- Easy to attract investors
- Can be more expensive to set up than a general partnership
- General partners are jointly and personally liable for business debts
- Must be registered with the state
A cooperative is run by the people who use the business. These user-owners benefit by sharing profits and are involved in decision-making.
Shares can be sold to generate more income for the co-op.
- Membership discounts available for user-owners
- Members do not pay taxes
- Establishment can be a complex process
- Filing fee for the co-op agreement
Non-profit organizations include charities, educational and religious groups. They can apply for tax-exempt status.
These businesses must file with the Internal Revenue Service (IRS) to request these exemptions.
- Provide beneficial work for the public
- No taxes paid on any profits
- Rules should be followed regarding profits
- Organizational rules can be complex
There are various things to consider when choosing the best legal structure. Your business plan will help you to reach a decision.
Ultimately, you need to select the entity that will help your business to succeed as well as allow for future growth. Choosing the right legal structure depends on both your business goal and how you want to organize your business.
Owners of sole proprietorships, LLCs and partnerships are required to pay taxes on net business profits.
This is not the case for other structures. For example, corporation owners will not pay tax on the net profits of the business.
Another benefit of the corporation structure is that taxes are often charged at a lower rate than individuals.
Sole proprietors are known as a pass-through entity. This means that the individual is liable for all taxes.
The riskier your business, the less personal liability you will want. This will limit additional business expenses.
If your industry has the potential to create a high litigation burden, it would be preferable to choose an LLC over a partnership.
As a sole proprietor, all legal liability for business activity is retained by the owner.
Structuring a business as a corporation allows shares of the ownership to be sold as stocks.
This will attract outside investment and stocks could also be offered as benefits to employees.
The process for transferring whole or partial ownership varies between business entities.
Changes in ownership can be easily made in corporations. This can be achieved by selling stock to existing shareholders or new shareholders.
Changing ownership for LLCs will depend on the terms of the business operating agreement.
Not-for-profit businesses are subject to different guidelines. This is because they are set up to create a service rather than to make a profit.
Non-profit status can mean eligibility for benefits such as income tax exemptions. An application must be made to apply for tax-exempt status.
If your business is publicly traded, annual accounts will be made available in the public domain.
If this is something you would rather not have, then you need to create a private company where there is no requirement to publish figures.
Different legal structures impose different decision-making processes. Think about whether you are comfortable with others being involved in these processes.
If you are confident to take the initiative, a sole proprietorship gives you the most control of this process. In this case, you will be responsible for all operations of the business.
However, if you prefer to take a hands-off approach, consider a limited partnership structure.
If you are creating a business with others, consider the relationship with your potential partners. There must be a degree of trust between business partners.
If you set up a general partnership, you could be liable for any debts your partner incurs on behalf of the business.
In this case, a limited partnership could be a better solution.
The structure with the least liability is a corporation. This is due to the business being treated as a separate entity in terms of the law.
Running a corporation or LLC involves more formalities than a sole proprietorship. Generally, the bigger the entity, the more paperwork is needed. For corporations, in particular, detailed reports of any business decisions must be kept. There are also formalities around electing who will run the business.
Sole proprietors need to produce the least amount of paperwork. This allows more time to focus on the day-to-day running of the business.
The type of legal entity will affect the number of shareholders you can have.
S corporations can have up to 100 shareholders. Depending on the size of your business, this may be adequate.
Larger businesses will be better choosing a C corporation structure. This allows for an unlimited number of shareholders and can attract greater investment opportunities.
If you have no plans to secure outside investment, an LLC structure is probably better. S corporations are also unsuitable for international investment.
For businesses looking to attract outside investment, incorporation is necessary. A C corporation allows investment opportunities. This structure involves additional paperwork and the completion of legal documentation.
Although sole proprietorships involve less paperwork and reporting, it is much more difficult to secure outside capital investment.
Depending on the type of industry, your business will be subject to different licensing laws and regulations.
You may need permits to operate. These will vary between states and relate to the activities of your business.
The cost of registering a business will vary depending on the type of business and the structure you choose.
A sole proprietorship or partnership may not require registration costs. A corporation or LLC will need to be registered and costs vary between states.
A business requiring a physical location will be more expensive to run than an online business.
If you are opening a business under a trade name, you will need to register a doing business as (DBA) name.
The costs for this vary between states. Generally, the cost will be less than $100.
Deciding on the legal structure of your business is an important consideration. Select the best one that suits your particular business needs. This will ensure your business can be as successful as possible.
Generally, sole proprietorships and general partnerships are the best choices for new start-ups.
As your business develops and grows, it may be necessary to change the structure. This may be costly depending on state regulations and tax issues.
It is always wise to contact a tax advisor, business lawyer or mentor for more information. A professional will be able to provide support and details specific to your case. This will help you reach the right decision.
Regularly reassess your business needs and goals to check you are operating within the best structure.
The legal considerations and costs vary between states. Take time to fully research the laws in your area to give your new business the best start.