Guide to Selecting Your Small Business Legal Structure
Things to consider and discuss with your attorney
One important consideration when starting your business is determining the best legal organizational structure. Why? Because it will affect operating efficiency, transferability, control, the way you report income, the taxes you pay and your personal liability.
Four basic structure types are available:
Sole proprietorship
Partnership — general and limited
Corporation — S corporation, C corporation
Limited liability company (LLC)
The choices can be complicated — and errors can be costly. Business legal structures are regulated by state governments, but your county or municipality also may have license requirements.
What’s more, current tax laws make it difficult to change your legal structure after you begin operating. Making the right decision before you open for business is very important.
How do you decide which legal structure is best for you and avoid potential problems? Consult with a certified public accountant (CPA). A CPA can help you make well-informed choices, explain how business structure affects your organization’s bottom line and file the necessary paperwork to start your business, if you’d like.
This overview and comparison grid will help you consider the right structure for your new business.
Overview
Sole Proprietorship
The simplest legal structure for any business
The business is not legally separated from you — the owner. (By default,the legal business name is the same as your legal name)
Establishing a business name separate from your own is possible by creating a “doing business as” (DBA) name. Most states require DBAs to be registered with the county clerk or Secretary of State
Owner can take cash withdrawals from the business at will
Owner required to make quarterly estimated tax payments• Establishing a sole proprietorship may be as simple as opening a bank account for the business
Some states and municipalities may require obtaining a license or permit
Partnership (General and Limited)
Like a sole proprietorship, a general partnership is not a legal entity separate from its owners
The difference between a sole proprietorship and partnership is that a sole proprietorship has only one owner and a partnership has two or more owners
Owners can take withdrawals and, if specified in the partnership, guaranteed payments
Owners pay taxes quarterly
Can be started through an oral agreement, though a written agreement is advisable (and required in some states)
Many states have legal provisions for limited liability partnerships (LLPs) that provide for some limitations on the liability of the owners and on points such as profit/loss percentages; business decisions; addition and withdrawal of a partner and terms of operation
Some partnership allocation structures may subject you and your business to heightened Internal Revenue Service (IRS) scrutiny
To form a partnership, you must register your business with your state,a process generally done through your Secretary of State’s office
C Corporation
A separate legal entity from its owners
Corporate documents are filed with the state and an annual fee is paid
Separate corporate bank accounts and records are created, and assets and money generated by the corporation are owned by the corporation
Corporations are required to pay federal, state and, in some cases, local taxes
Most businesses must register with the IRS and state and local revenue agencies. Although any business that has employees will need to get a tax ID number, it is required for a corporation
Unlike sole proprietors and partnerships, corporations pay income tax on their profits. In some cases, corporations are taxed twice — first, when the company makes a profit, and again when dividends are paid to share holders on their personal tax returns
Shareholders who also are employees pay income tax on their wages.The corporation and the employee each pay one half of the Social Security and Medicare taxes, but this usually is a deductible business expense for the corporation
To form a corporation, you must file articles of incorporation with your state,a process generally done through your Secretary of State’s office
S Corporation
A corporation with the Subchapter S designation from the IRS
To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered
An S corp is different from a C corp in that its profits and losses can pass through to the owner’s personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. Losses are limited to the shareholder’s tax basis
Shareholders can be paid wages, receive distributions of profits or a combination of wages and distributions
Limited Liability Company (LLC)
A hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership
The “owners” are referred to as “members.” Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs
Unlike shareholders in a corporation, in most states LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would
To form an LLC, you must file the appropriate documents with your state,a process generally done through your Secretary of State’s office
Operation and Control
Although liability and tax implications are important, the legal structure of your business will dictate certain aspects of how you operate in the years to come.
Sole Proprietorship
Controlled by one person
All liability rests on the owner
Partnership — General
General partners have equal management rights and control, if not otherwise specified in a partnership agreement
Responsibilities and control can be defined in a written partnership agreement
Partnership — Limited
Management and control of the business handled by the general partners
Partners’ liabilities limited to their investment
Corporation — C and S
Bylaws (operating rules) created to establish and explain the rules governing the organization
Shareholders have sole authority to approve articles of incorporation, mergers and dissolution of the company and elect the directors
Directors are responsible for major decisions, including selection of company officers
Limited Liability Company
Single-owner LLCs operate like sole proprietorships
Investment
Sole Proprietorship
No outside investments permitted
Partnership — General and Limited
All partners have equal ownership of all business assets and liabilities unless otherwise defined in partnership agreement
Ownership percentages can vary based on the number of partners and the written agreement, which should also explain how a departing partner will be paid for part ownership when he or she leaves, dies or retires
Corporation — C
Can issue different classes of stock and bonds, subject to state and federal securities laws and regulations
Corporation — S
Can issue one class of stock to up to 100 shareholders
Limited Liability Company
Rules similar to a proprietorship for single-member LLCs, and to a partnership for multiple-member LLCs
Continuity and Transferability
Even though you’re just starting out, you should begin with the end in mind. What will happen to your business when you retire or die? Each legal structure provides a different answer.
Sole Proprietorship
Continues until abandoned or upon death of the owner
Assets and liabilities can be freely transferred by selling all or a portion of the assets
Partnership — General and Limited
Dissolves if a general partner dies or leaves the partnership, unless the agreement provides for continuation of the business by the remaining partners
Corporation — C and S
Exists in perpetuity even if one or more owners die
Ownership can be transferred by sale of stock
Limited Liability Company
For multi-owner LLCs, continuity and transferability are determined by the organizing and operating documents and may affect the LLC’s ability to choose corporate or partnership tax status
Legal Liability
For many business owners, liability is a serious concern. Although a CPA can provide you with detailed advice on the tax implications of various legal structures and general advice on liability protection, you should direct any specific liability questions to an attorney who specializes in corporate law. Additional liability protection is available to any business structure by purchasing insurance.
Sole Proprietorship
Unlimited personal liability
Partnership — General and Limited
General partners are fully liable for all liabilities of the partnership, no matter which general partner incurred them
Limited partners are responsible only to the extent of their investment
Corporation — C and S
Shareholders are generally liable only to the extent of their investment in the business, but management generally incurs some personal liability
Limited Liability Company
Liability rules are similar to corporate shareholders. Members are not personally liable for the debts and liabilities of the LLC
Compensation and Payroll Taxes
Employees are paid a salary, and federal, state, Social Security and Medicare taxes are withheld. The employer matches the Social Security and Medicare taxes withheld for each employee. An individual who is self-employed pays federal, state, Social Security and Medicare taxes on net self-employment income.
Sole Proprietorship
Must pay self-employment taxes as part of quarterly estimated tax payments
Partnership — General and Limited
General partners subject to self-employment taxes on their share of self-employment income from the partnership (whether or not distributed
Limited partners are not subject to self-employment taxes
Corporation — C and S
Income and Social Security taxes withheld from wage income paid to shareholder employees
Limited Liability Company
Treated according to the tax treatment selected
If treated as a partnership, active members pay quarterly estimated self-employment taxes
Inactive members not subject to self-employment taxes
Tax Years
Although most businesses operate on a calendar year, in some cases your company may benefit from a fiscal year different from the calendar year. Except for a sole proprietorship, which can only operate on a calendar year, generally other legal structures can elect a different tax year subject to IRS regulations. Because of the tax complexities of operating on a fiscal year, you should only consider this option if you have a sound business purpose for doing so. Your CPA can help you make this determination.
Which Legal Structure is Right for Your Business?
There are many factors to consider, from business type to tax implications. The chart on page 11 summarizes the pros and cons of each structure. A CPA has the background and expertise to help you make your decision — and form your business properly from the start.
Sole Proprietorship
Pros
Inexpensive to start and simple to run
One level of tax on net income
No separate tax return
Cons
Unlimited personal liability
Ownership limited to one person
Partnership
Pros
Ownership not limited to one person
One level of tax on net income
Income and expenses allocation
can be unrelated to percentage of ownership
Cons
Unlimited personal liability
Each partner legally responsible for the business acts of other partners
Requires separate tax returns
S Corporation
Pros
Limited personal liability for shareholders
Business net income taxed as personal income of shareholders
Cons
Requires separate tax returns
Restrictions on adding investors
Net income must be allocated according to percentage of ownership
C Corporation
Pros
Limited personal liability for shareholders
Easy to transfer ownership/add investors
Perpetual continuity presumed
Cons
Requires separate tax returns
Net income may be double taxed
More costly to set up and maintain
Limited Liability Company (LLC)
Pros
Limited personal liability for members
Income and expenses can be allocated in a manner unrelated to percentage of ownership
Cons
Not automatically perpetual like S or C corps
More costly than a sole proprietorship to set up and maintain
Other Considerations
Your CPA can help you decide what type of entity and structure is best for your particular situation and type of business.There are situations where forming multiple entities may better accomplish your objectives. For example, a family business may want to separate its land, buildings or other fixed assets from the operating business and lease them back to the operating business to have a different equity ownership by family members who may not be active in the business’s day-to-day operations.
You should evaluate the decision to choose an entity in which the tax attributes pass through to the owners in light of the other income or losses that you and other owners have and the extent to which you will have a tax basis in the entity.Other considerations include your objectives for an exit strategy or transitioning the business ownership on to the next generation.
© 2015 American Institute of CPAs. All rights reserved. 15607-312
