Why Structure Matters
One of the most important components of a healthy, successful business is something most people will never see—the business legal structure.
For the most part, customers and vendors don’t really care about how you’ve legally set up your company. However, your legal structure will make a lot of difference for you and any potential investors you might want to bring on board.
The legal structure of your business determines your legal liability and the way you and your business will have to operate and pay taxes.
For these reasons, it’s critical to take some time to think through how your business is currently set up or how you want it to be structured when you begin.
Here’s a quick reference to the types of common business structures in the United States.
And please, remember that at GoCoOpe, we’re not lawyers or CPA’s. This blog post does not constitute legal or financial advice.
This is simply a guide from our experience and research. Please get informed on the subject by reading some books (to keep the cost down), and then a good business or tax lawyer or a CPA who can help you choose and implement the right structure for your particular situation.
As its name suggests, only one person can own a sole proprietorship. In this structure, there’s no legal distinction between the owner and the business. The owner pays all taxes for the profits and losses of the business.
Sole Proprietorship is the easiest business structure to begin and terminate. The owner has complete control.
It has tax advantages because there’s no corporate taxes. The owner is only taxed once on company profits.
The disadvantages to this structure are that the owner is also liable for everything. The owner is legally responsible for all debts in the business, and his or her personal assets are at risk if the company is ever sued.
Due to the owner’s total liability, it’s difficult to attract investors to this type of investment. Most do not want their funds getting mixed in with personal interests.
In a partnership, there is more than one owner, but as with a sole proprietorship, the owners take on all of the liabilities and legal risk of the company. Each owner is taxed for their share of the profit and losses of the company.
You can start and grow your business with the help of your partner. They are legally recognized as an owner of the business, and so can carry out all the common tasks that would require an owner.
There’s much less paperwork involved to start a partnership.
Taxes are simple and straightforward. The owners are taxed according to the profit and losses of the business. The business is not taxed.
You and your partner(s) are equally liable for all debts and equally liable for any legal actions concerning the business. Everyone’s personal assets would be at risk in the event of a lawsuit or debt collection.
Due to the high personal risk of a partnership, it is also hard to raise capital among investors with this type of a business structure.
You need to manage your relationship with all partners involved. This can sometimes be the hardest part of a partnership.
The most well known of all the business structures, the corporation is a company owned by a group of individuals called shareholders.
The company is set up as a separate legal entity. This offers the owners more protection from personal liability in the case of legal actions against the company.
The owners are also safe from the company’s debts. They’re not personally responsible to pay off debts incurred by the company.
With this structure, the company must pay its own taxes. The shareholders only pay taxes on the salaries, wages or dividends they earn. There are also other tax advantages that this structure may provide to shareholders and other executives.
This structure uses stock to define how much is owned by each stockholder, helping lay a groundwork for potential issues with other owners.
A Corporate legal structure may become complicated and the fees associated with them are higher than other forms.
There is more paperwork involved in setting up and operating them. Corporations are typically taxed on both profits and the dividends paid to shareholders.
S Corporation (S-Corp)
S Corporations are a subset of the corporation structure. Like corporations (C-Corp), the company is given legal rights as a separate entity from the shareholders but are a pass-through entity similar to partnerships, and share the same advantages and disadvantages of the corporation (C-Corp), except as noted below:
S corporations are pass-through entities so they do not pay corporate tax. Just like the partnership, the shareholders pay taxes based on the profit and losses of the company. This can be more advantageous than filing and paying two types of taxes.
There are size and stock class restrictions, so be sure to have all the information before using this structure.
Limited Liability Company (LLC)
The sole proprietorship and the corporation structures are like the polar ends of a spectrum. One is simple for owners, yet the owners take on all company risks personally. The other is complex for owners to operate, yet the shareholders are protected personally from much of the risk of running the company.
The middle ground is the Limited Liability Company.
LLCs are interesting because the IRS does not acknowledge the LLC as a taxable structure. So if you form an LLC, which normally simplifies the operation of an organization at the State level, you must tell the IRS how you want to be taxed, by defining your entity to the IRS as one of the structure types above (sole-proprietor, partnership, C-corp or S-corp). Otherwise, the IRS will default the LLC to a sole-proprietor or partnership tax type, depending on the number of members that the LLC has.
While being around for a number of years, the LLC has been growing in popularity among entrepreneurs, and for good reason.
LLCs typically have simpler operational and State requirements.
In an LLC, the owners (called members) are for the most part protected against legal actions towards the company or debts incurred by the company, like a corporation. In other words, the members’ personal assets are protected from legal liability for debts and legal actions.
LLCs default to pass-through organizations, but can be organized with a corporate tax structure if the proper IRS forms are submitted. So LLCs can be taxed in many ways, depending on how they are formed.
For a much deeper look at how LLCs are taxed, please read this helpful article from Nolo.com.
Since LLCs are one of the newest corporate structures and are treated differently at the State and Federal levels, there may be some confusion on how they work. So we would highly recommend that you work with a knowledgeable business attorney, tax attorney and/or CPA to operate and maintain them. A partially informed individual might tell you that LLCs are pass-through entities, when this may not always be the case.
What structure should you start with?
Are you not sure which structure is right for you? Don’t worry!
In most cases, entrepreneurs can start their companies as a sole proprietorship or partnership, and then later choose to change their legal structure to a corporation or LLC. But this may not be cheap or easy, so please get educated about the different structures, and consult a business or tax lawyer or CPA (or all three), and consider your options carefully.
We highly recommend you work with a business and/or tax lawyer and/or CPA to discuss your particular situation. It will be worth their fee to get this decision right from the beginning.
You can save money by buying books on the subject before consulting a professional. The more you know before hiring them means less time they charge you for your education. Here are some resources we recommend:
Form Your Own Limited Liability Company by Anthony Mancuso, Attorney.
LLC or Corporation?: How to Choose the Right Form for Your Business by Anthony Mancuso, Attorney.
Now, go grow your business.