Which Legal Structure Is Right For Your Small Business?
In the midst of entrepreneurial pursuits sometimes the most frustrating thing to do is slow down and think about things like legal structures, contracts, and accounting. Yuck.
But it's not a real business without those things.
Company structures aren't as overwhelming as they sound, and we want to help make it easier for you to understand and choose the right fit. So if you have a brilliant idea and are ready to get going on your new venture, take a few minutes and research company structures below so you have a solid foundation for your business. Here are the options that most small businesses choose between:
1. Sole Proprietorship
This is by far the fastest setup for starting a business. There's virtually no paperwork, and it's easy to start selling right away. There are no separate tax filing requirements, and no filing fees to start. You might need local licenses and permits depending on the business, but otherwise you are automatically a Sole Proprietorship when you start selling. The only other step you might need to take is filing a Fictitious Name or DBA (Doing Business As) with your state, which is usually less than $100 including filing the paperwork and getting it published in a local paper (a requirement).
- Fast formation (almost no paperwork!)
- Simple Taxes (you pay taxes as part of your personal return so it's very simple)
- Personal Liability (no protection - which means you're responsible for the debts and obligations of the business)
- Difficult to Get Investors (you can't sell stock)
2. General Partnership
A partnership is a lot like a Sole Proprietorship but with two owners. A general partnership is the easiest to form, but it also doesn't provide a lot of protection for the individual partners. The most important thing to do aside from filing paperwork with your state, is create a partnership agreement. Your partnership's legal name is the last names of the all the partners, but you can also file a DBA to use another name. Partnerships don't pay taxes as a company, but they file an annual "information return" that shows the pass-through income that is taxed on the partners' individual returns. It's definitely worth discussing partnership options with a lawyer, and getting advice and help creating your partnership agreement.
- easy to form (simple filing at relatively low cost)
- taxes are fairly simple
- shared financial commitment between partners
- shared time and work commitment
- joint liability (it's all on the partners so they are all personally liable for the company debts and obligations and each other's actions)
- disagreements (can happen and can be detrimental)
3. Limited Liability Partnership (LLP)
Limited Liability Partnerships are more complicated than General Partnerships, but they do offer more protection for the partners involved. The partners are not individually liable for all debts, obligations, and management decisions - it depends on their percentage of investment. You will still have to file paperwork, plus an "information return". Just as with a General Partnership, it's definitely worth discussing partnership options with a lawyer, and getting advice and help creating your partnership agreement.
- protection against some liability
- shared financial and time commitments
- ability to attract good employees (incentive to become a partner)
- disagreements (can happen and can be detrimental)
- shared profits (can cause tension)
4. Limited Liability Company (LLC)
The LLC is one of the most flexible and common structures for small business. It consists of one or multiple owners, known as members, who have limited liability like in a normal corporation, but are taxed on their individual returns (pass-through) like a partnership. To form an LLC you must file with your state, which is typically a bit cheaper than filing as a corporation, but more than a partnership or assumed name. Just like with the types of partnership, we highly recommend seeking advice from counsel before choosing to file as an LLC.
- liability is limited for the members
- it is cheaper and easier to file taxes and paperwork for an LLC compared to a corporation
- profit can be distributed however the operating agreement allows (it's up to the members so it's more flexible)
- more effort to file than becoming a sole proprietor
- typically if somebody leaves the LLC is automatically dissolved and a new one must be reformed (you can protect against this in your operating agreement if you want to)
A corporation is very common for larger businesses, and something most people are familiar with. It is owned by shareholders, and is considered it's own entity. It is one of the most complex company structures, and you should definitely consult an attorney before forming one. You will need to file with the state and potentially issue stock certificates when you start. You have to get tax IDs from the state and IRS and pay federal, state, and in some cases, local taxes. Income is often double taxed because the corporation pays income taxes, and then individuals pay taxes on their dividends.
- limited liability - the shareholders are protected
- it is possible to raise funds by selling stock
- owners pay taxes on profits in salaries, bonuses, and dividends, but additional profits are often taxed at a lower rate
- they are expensive and difficult to form and operate
- double taxation - when the company makes a profit and when shareholders receive dividends
- lots of paperwork!
Many small businesses choose to elect their corporations to to become S-corporations with the IRS because it makes it possible to use pass-through taxation, to avoid double taxing. That way, the business does not pay taxes, rather, the individuals do, like in a partnership or LLC. It's important to note that some states don't recognize S-corps and will tax them like C-corps, so you will want to seek advice of an accountant before you get started.
- tax savings for members
- some shareholders/employees can write off expenses like health and life insurance
- stricter rules for operations (director and shareholder meetings, updates to by-laws, etc
- shareholders must have high enough compensation (no low salary/high distribution)
A coop is a business that's owned by the members who purchase shares called user-owners. Members have voting power and elect a board of directors and officers who run it. The cooperative is like a corporation with pass-through taxes (no federal income tax as a company, but individuals pay it on their earnings. It's a very complex business structure, and unless you're starting a healthcare, retail, agriculture, art or restaurant business it might not be a great structure to choose. If you do think it's the right fit, it's a much different process than the other structures to get started. The members must agree on the business plan and then the group can (not required) incorporate. Bylaws must be created, membership applications must be drafted, and you have to have a charter member meeting to elect directors. All states have different laws regarding cooperatives. Due to the complex nature of starting a cooperative you should definitely get the help of counsel in forming one.
- every member gets an equal vote - all investors and members count
- the cooperative is more fluid - people can come and go without hurting the business
- tax savings from pass-through taxation
- relies on member participation from voting to working
- might need investors, but hard to get them to agree to fund, because more shares don't mean more decision making power during votes
That was a lot of difficult reading! But it's worth it to know what the right move is when forming your business. Before you start it's also a good idea to consult with an attorney, and you can find a lot more helpful information from the Small Business Administration.
Still have questions? Comment below and ask us anything!