Choosing a Legal Structure for Your New Business
By Kerry Woodson
In the midst of the excitement of planning a new business, many entrepreneurs fail to adequately evaluate and determine the best type of legal organization they should form for their particular circumstances. Ask an attorney what is the best business entity and you will probably get an “it depends” answer. No single structure is best for all situations, which is why a potential business owner should educate himself about the pros and cons of the various business structures available today. Most businesses choose one of the following arrangements: (1) sole proprietorship, (2) partnership, (3) S-Corporation, (4) C-Corporation, or (5) Limited Liability Company (LLC). While we can’t cover all the intricacies of each one, let’s look at some of the highlights of these popular organization types.
The sole proprietorship is the most basic structure, the easiest to set up, and therefore the one that many people choose almost by default. It is also the one with some of the biggest drawbacks. In a sole proprietorship, there is basically no distinction between the business and the business owner in the fact that the owner has unlimited liability. If the business can’t meet its obligations, the owner’s personal assets (home, car, savings) are at risk of being lost. Profits are passed directly to the owner to declare on his/her personal tax return. This option is for the person looking for a simple entity with few legal requirements and who is not concerned about liability.
A partnership shares many of the attributes of a sole proprietorship except that there are multiple owners. While partnership agreements can be structured to accommodate various scenarios, one thing to keep in mind is that a general partnership commits and binds all the participants to actions made by other partners. In other words, if one partner enters into an agreement on behalf of the company, everyone is obligated, even if they had no knowledge of the action and, like a sole proprietorship, each one has unlimited liability. It’s been said that the quickest way to lose a friend is to enter into a partnership with them. Although the financial costs can be substantial, they sometimes pale in comparison to the relational tolls extracted on a friendship. Money matters and control issues have a way of turning congenial people into combatants.
A corporation differs in the fact that it is considered a separate entity from the owner(s) and offers a certain level of liability protection. Corporations are more complicated to create and require more formalities and record-keeping but can be well worth the extra effort. Depending on the situation, companies will elect between a C-Corporation and an S-Corporation. An S-Corporation pays no corporate income tax as all income is passed directly to the shareholders. A C-Corporation is taxed directly on the company’s profits and only dividends (if any) are taxed at the individual level. Of course, any salaries are reported on a W-2. An S-Corp has a few limitations while a C-Corp offers more flexibility so it’s important to consult an attorney to help decide which option is best for you.
A Limited Liability Company (LLC) is a relatively new type of organization. It combines some of the best features of the other options like the limited liability of a corporation, multiple owners as in a partnership (a single owner is also allowed), and less formality like a sole proprietorship. The company can elect the pass-through type of taxation like an S-Corp or can choose to be taxed like a C-Corp. There are still some initial filings that must be made to create the entity and other annual reports filed but the burden is much lighter than the typical corporate requirements. Many entrepreneurs are deciding that this route is the best choice for them because of its combination of benefits.
Obviously, these descriptions are very brief and not meant to serve as your final source but to provide a glimpse of some of the options available to you. Nothing can replace taking the time to seek the advice of a competent professional attorney and tax advisor. Doing things right initially can prevent headaches later.
By Kerry Woodson
In the midst of the excitement of planning a new business, many entrepreneurs fail to adequately evaluate and determine the best type of legal organization they should form for their particular circumstances. Ask an attorney what is the best business entity and you will probably get an “it depends” answer. No single structure is best for all situations, which is why a potential business owner should educate himself about the pros and cons of the various business structures available today. Most businesses choose one of the following arrangements: (1) sole proprietorship, (2) partnership, (3) S-Corporation, (4) C-Corporation, or (5) Limited Liability Company (LLC). While we can’t cover all the intricacies of each one, let’s look at some of the highlights of these popular organization types.
The sole proprietorship is the most basic structure, the easiest to set up, and therefore the one that many people choose almost by default. It is also the one with some of the biggest drawbacks. In a sole proprietorship, there is basically no distinction between the business and the business owner in the fact that the owner has unlimited liability. If the business can’t meet its obligations, the owner’s personal assets (home, car, savings) are at risk of being lost. Profits are passed directly to the owner to declare on his/her personal tax return. This option is for the person looking for a simple entity with few legal requirements and who is not concerned about liability.
A partnership shares many of the attributes of a sole proprietorship except that there are multiple owners. While partnership agreements can be structured to accommodate various scenarios, one thing to keep in mind is that a general partnership commits and binds all the participants to actions made by other partners. In other words, if one partner enters into an agreement on behalf of the company, everyone is obligated, even if they had no knowledge of the action and, like a sole proprietorship, each one has unlimited liability. It’s been said that the quickest way to lose a friend is to enter into a partnership with them. Although the financial costs can be substantial, they sometimes pale in comparison to the relational tolls extracted on a friendship. Money matters and control issues have a way of turning congenial people into combatants.
A corporation differs in the fact that it is considered a separate entity from the owner(s) and offers a certain level of liability protection. Corporations are more complicated to create and require more formalities and record-keeping but can be well worth the extra effort. Depending on the situation, companies will elect between a C-Corporation and an S-Corporation. An S-Corporation pays no corporate income tax as all income is passed directly to the shareholders. A C-Corporation is taxed directly on the company’s profits and only dividends (if any) are taxed at the individual level. Of course, any salaries are reported on a W-2. An S-Corp has a few limitations while a C-Corp offers more flexibility so it’s important to consult an attorney to help decide which option is best for you.
A Limited Liability Company (LLC) is a relatively new type of organization. It combines some of the best features of the other options like the limited liability of a corporation, multiple owners as in a partnership (a single owner is also allowed), and less formality like a sole proprietorship. The company can elect the pass-through type of taxation like an S-Corp or can choose to be taxed like a C-Corp. There are still some initial filings that must be made to create the entity and other annual reports filed but the burden is much lighter than the typical corporate requirements. Many entrepreneurs are deciding that this route is the best choice for them because of its combination of benefits.
Obviously, these descriptions are very brief and not meant to serve as your final source but to provide a glimpse of some of the options available to you. Nothing can replace taking the time to seek the advice of a competent professional attorney and tax advisor. Doing things right initially can prevent headaches later.
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