When starting a business, selecting the right type of legal structure is a critical element.
There are five basic types of legal structures to choose from: sole proprietorship, partnership, LLC, corporation, and S corporation.
In addition to being necessary for government taxation and reporting, the right legal structure can add to the operational efficiency of your business.
5 Types of Business Legal Structures
Each legal structure possesses its own unique characteristics, so your initial goal should be to choose the structure that will work best for your business.
1. Sole Proprietorship
The most widely used type of legal business structure is the sole proprietorship.
This is selected by individual persons that own their business, which makes them responsible for the entirety of its debts and entitled to 100 percent of the profits.
This is the simplest legal structure, and provides business owners with total control over their business with minimal government interference. However, business owners of a sole proprietorship are help personally liable for any business debts, resulting in the possible loss of their personal assets.
Advantages of Sole Proprietorship:
- Easy to start.
- You keep 100 percent of the profits.
- Tax is paid as personal income and not business income.
- Business can be dissolved whenever you choose.
- You are the boss.
Disadvantages of Sole Proprietorship:
- Limited ability to raise investment capital.
- Life of business is directly tied to the life of the owner.
- You are held personally liable for all debts, lawsuits, or settlements.
A partnership is a business owned by two or more people who are both entitled to the profits.
Partnerships are very similar to sole proprietorships in that they are easy to start, all partners assume full liability for the business, and share the same tax structure.
The profits and losses of a partnership are shared based upon the percentage outlined in the written partnership agreement.
Due to the added liability concerns of being responsible for a partner’s business debts, partnerships are typically the least recommended route of business ownership.
Advantages of a Partnership:
- Easy to get started.
- Access to more investment capital.
- Must only pay personal income tax.
Disadvantages of a Partnership:
- Partners may disagree on the direction of the business or its operations.
- All of the profits must be shared.
- Limited business life.
- Both partners are subject to unlimited liability.
Unlike other legal business structures that are directly tied to the owners, corporations are their own entity and have the same responsibilities and rights as a person.
Thus, its existence is not dependent on its owners.
Related: An Introduction to Business Plans
A corporation has the same legal rights as a person, which allows it to be sued, buy and sell property, and sell ownership rights in the form of stocks.
Establishing a corporation is a complex procedure, and the increased rights and flexibility results in increased taxation as well.
Advantages of a Corporation:
- Ability to raise a large amount of investment capital.
- Easy transfer of ownership.
- Corporations can exist indefinitely.
- Liability exposure to stockholder is very limited.
Disadvantages of Corporations:
- Corporations are subject to double taxation and capital stock tax.
- Expensive start-up costs.
- Closely regulated by federal agencies.
4. S Corporation
S corporations provide business owners with attractive tax benefits and the limited liability of a corporation, making them much more appealing to small business owners.
Unlike standard C corporations that must pay double taxes, S corporations pass profits and losses directly through to the shareholders who report them on their individual tax returns, enabling them to pay for only one level of federal taxes.
Advantages of S Corporations:
- Limited liability exposure to stockholders.
- Much lower taxation than C corporations.
- Ability to raise substantial amount of capital.
- S corporations without inventory can utilize the cash method of accounting instead of the more tedious accrual method.
Disadvantages of S Corporations:
- Still have higher taxation than sole proprietorships, partnerships, and LLC’s.
- Expensive start-up costs.
- Must hold directors and shareholders meetings.
- Only one class of stock can be issued.
5. LLC (Limited Liability Company)
LLC’s are a hybrid legal business structure that is relatively new to the business environment and now allowed in most states.
The hybrid design of LLC’s provides the reduced taxes and flexibility of partnerships and sole proprietorships and the limited liability afforded by corporations.
Forming an LLC is more complicated than forming a standard partnership, but much less complex and expensive than forming a corporation.
Advantages of an LLC:
- Reduced taxation due to profits being taxed at the member level.
- Limited liability exposure.
- Can choose to be taxed as a C-corp or S-corp, a partnership, or a sole proprietor.
- Can be established by one owner.
- No annual shareholders meeting required.
- No risk of losing control and decision making power to a board of directors.
- Unlimited business life.
Disadvantages of an LLC:
- Earnings are subject to self-employment tax.
- LLC’s organized like a partnership cannot use incentive stock options.
- Lack of uniformity and consistency amongst LLC statutes in different states, which makes it difficult to operate in more than one state.
What to Look for When Evaluating a Legal Business Structure
While many factors should be evaluated when selecting a legal structure for your business, not all of them apply to every business.
However, the following factors will most likely apply to your business, regardless of its size:
Who will have the decision making power and control over the business?
The key decision maker will determine the allocation of profits, control management, decide on loans and expenditures, and be solely responsible for the business’s profits and losses.
The tax liability of a business can be quite substantial and greatly affect the success of a business.
Some legal structures protect personal assets from being subject to business debts and others do not. This makes liability a significant consideration when establishing a legal structure for your business.
4. Ownership Transferability
Some legal structures allow for the transfer of ownership with the signing of a single piece of paper.
5. Business Longevity
Some legal structures allow a business to be perpetual, while others cease the existence of a business when the principal owner retires or passes away.
6. Ability to Raise Capital
Corporations and LLC’s have the ability to raise substantially more capital than sole proprietorships and partnerships.
Choose the Right Legal Structure for Your Business
With so many factors to consider, the task of choosing a legal structure for your new business can seem daunting.
However, it really comes down to the type of business that you have, the amount of control you want over it, and the expected future growth of your business.
If you are starting a local landscaping company, then a sole proprietorship or partnership is likely the best choice. On the other hand, if you are launching a start-up tech company, then the features of a corporation or LLC might prove beneficial.
Starting a new business is an exciting and challenging endeavor.
Selecting the right legal structure from the outset can save you a lot of time and money, allowing you to focus on growing your business.
By examining the features and benefits of each of these legal structures and considering your own business needs, you will be able to select the right legal structure for your business and be well on your way to enjoying a life of entrepreneurship.
What do you think, which business legal structure is best?