(Shutterstock)

(Shutterstock)

The Many Shades of Structure

What legal structure is best for my business?

Back Web Only Sep 9, 2015 By Coral Henning

For many years, I have been making furniture that I sell to friends and family, and at local fairs and boutiques. It has become so successful that I’d like to work toward officially starting my own business. I know there are many ways I could set up my company; how do I know what will be best for me?

There are many legal structures your business may take. You will need to carefully review your business and determine which structure will best fit your needs. Keep in mind that if you start with a simple structure, you can always change to a more complex one in the future, when your business grows or your needs change.

There are four common legal structures you may want to consider for your business: Sole proprietorship, partnership, limited liability company (LLC) and corporation. Other business structures exist but are not as common. There are many differences between each type of structure, but the issues that most people are concerned about are discussed briefly below.

Personal liability

Many business owners are concerned about whether they are personally liable for the debts their business incurs, or if it will be the company that gets sued. This is one of the main differences between business structures.

Sole proprietorships and partnerships are legally inseparable from their owners, leaving the owners personally liable for business-related obligations. This means that the owner is personally responsible for everything from debts to lawsuits. Additionally, in a partnership, all partners are equally bound by the business actions of all other partners, so you could be held responsible for your partners’ actions too. Personal liability can be a concern if your business is very expensive to run and thus incurs a lot of debt — or if your business is particularly risky, opening you up to lawsuits.

Corporations and LLCs are separate legal entities from their owners and thus responsible for their own debts and lawsuits. The owners’ personal liability for business obligations is greatly reduced. Owners are still personally liable for loans for which they offer personal guarantees, negligent or intentional acts, breach of fiduciary duty and in some cases business-related tax obligations. Other than those types of situations, the business itself is liable for business obligations.

Ease of setting up and maintaining your business

Most business owners don’t go into business because they want to do paperwork; they want to run their business, and provide their goods and services. The amount of paperwork and reporting required varies between business structures, and the owners’ ability and willingness to do this paperwork can be a deciding factor in the choice of business types.

There are no fees or paperwork required to create a sole proprietorship or partnership; the business exists as soon as you start working. You may need to obtain the proper permits or licenses required to perform the type of work your business provides, such as a seller’s permit. Throughout most of California, you will also need to register your business with the city or county. Although it is not required when setting up a partnership, it is usually a good idea to write a partnership agreement that formalizes your relationship with your partners, establishes roles and responsibilities of each, and details matters such as profit and loss sharing or what happens if one partner chooses to leave.

Corporations and LLCs are more complicated to set up. In addition to the permits, licenses and registrations you need for all new businesses, with corporations and LLCs you must file paperwork to formally establish the business. “Articles of Organization” or “Articles of Incorporation” must be filed with the Secretary of State along with a registration fee (typically $70-$100). You will also need an operating agreement for an LLC or bylaws for a Corporation, which will formally describe the financial and working relationships between owners and detail issues such as rules for holding meetings, decision-making and ownership transitions.

In addition to the extra paperwork involved in setting up the business, corporations and LLCs require additional reporting and other paperwork throughout the year. In order to maintain your status as an LLC or corporation (and the protections and benefits of these business structures), you may need to prepare quarterly or annual reports, prepare agendas and minutes for legally required meetings, and document business decisions.

Taxes

Some business structures, such as sole proprietorships and S corporations, are considered “pass-through” entities for tax purposes. This means that the business itself does not pay any taxes. Instead, the business’ profits and losses are passed through to the owners, who pay taxes on income and deduct losses on their individual tax returns. This can simplify taxes and ensure that profits are only taxed once. However, pass-through taxation means the owners pay taxes on profits they never receive because the money was put back into the business rather than the owner’s bank account.  And because profits are passed to the owners, all income is taxed at the individual income tax rate, not the (typically lower) corporate rate.

Other structures, such as C corporations, are considered separate entities from the owners and pay their own taxes on business income and losses. Overhead such as salaries, benefits and business expenses are subtracted from earnings, so many small corporations have very little left in the way of profits.  Profits are typically taxed at a rate significantly lower than that of individual income taxes. However, if you have shareholders who aren’t active employees to whom you pay dividends, these dividends will be double-taxed; once at the corporate level and again on the shareholders’ individual taxes.

There are some business structures, such as partnerships and LLCs, which allow the owners to choose to be taxed as either a corporation or a pass-through entity. This flexibility allows the owners to choose the taxation method that best benefits them at tax time. For more information, see the IRS Business Structures website for details about the tax forms and filings required for each type of business.

There are, of course, many other differences between the various structures, which you will want to carefully research and consider before making a decision. For more information, visit the U.S. Small Business Administration’s website, which  offers detailed descriptions of each business type, as well as information about writing business plans, links to forms you may need to set up your business, and a variety of other useful information about starting and running a small business.  Nolo Press has compiled this handy chart detailing the main advantages and disadvantages of each business structure.

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