Determine the Legal Structure of Your Business
Consider the following situation: You have a brilliant business idea and have planned your business down to the last detail. You are most probably ready to get going. But, hold on. Did you choose a legal business structure? If not, you might want to decide the same before starting out.
Though picking an option amongst several similar-looking ones might seem intimidating at first, picking the right one can save your business from several legal hassles later on.
A proper legal structure decides whether you’ll stay on the good side of the law or not, both literally and figuratively.
Want to know how? Follow along to find out.
Why Does the Legal Structure of a Business Matter?
Against popular belief, a legal structure not just decides the taxes you’ll pay. It also decides the level of risks to your personal assets (your personal savings, car, house, etc.) and your business’s ability to raise funds through loans and investments.
Going through all of your options can help you decide which one fits the best for your business. Moreover, it also helps you finalize if you would need an attorney’s help or not.
So, if you want to get a quick overview of what different types of business structures would look like, read on.
What Are Different Types of Business Structures?
Depending upon the type of ownership, liability on personal assets, and size of the firm, the following legal structures exist in the US:
- Sole Proprietorship
Suppose you plan on selling artwork, retail products, or any product or service under the sun for that matter. Also, you want to go through as little paperwork and legal procedures as possible.
Then a sole proprietorship might be for you. Especially, if you plan on starting the business under your name, you might not have to do any paperwork at all.
Even if you want to have a domain name, registering your domain name would be the only legal procedure you’ll have to go through. And that’s fairly simple and inexpensive.
Hence, a sole proprietorship is a perfect business structure type for those who have a product or service and wish to start selling it right out.
How to form a sole proprietorship?
A sole proprietorship is fairly simple to form. If you have your business idea and plan sorted, you can start your business. Without any official registration or legal framework whatsoever.
Although you should keep in mind that depending upon your industry you might need to get some licenses and permits before you start.
If you are doing business under a name other than your own, you would also have to get a DBA or “ doing business as.”
A sole proprietorship has the following advantages:
- Easy to set up: A sole proprietorship is fairly easy to set up and involves little or no legal hassles.
- Relatively Inexpensive: Setting up a sole proprietorship is the cheapest of all legal structures. All you have to pay is a small fee for a business license and business tax depending upon the location of your business.
- Dissolution is easy: As your business has no stakeholders except you, the dissolution can happen without any disagreements or problems.
- You are the sole benefactor of profits and sole bearer of losses: Your profits belong only to you and you aren’t answerable to anyone for your losses.
Although sole proprietorship might look like a great option right now, it has its fair share of disadvantages too. Which are as follows:
Liability on your assets: As you and your business are a single legal entity, if things go south your personal assets would be in danger. i.e., you’ll have to pay the debts incurred through your business using your personal assets.
Difficulty in raising capital: It is tougher for sole proprietors to acquire a small business loan or funding. Banks are often less willing to give loans to sole proprietors as they are considered less credible. Also, you cannot sell stocks to generate funds as a sole proprietor.
Limited tax savings: Sole proprietorships do not get tax benefits like corporations do for offering benefits like medical reimbursements and insurances to their employees.
Suppose you are an architect and want to start a firm with your friend who’s an interior designer.
Depending upon the ratio of contributions you make towards the working of the firm you’ll have a certain share in profits and losses of the firm.
It can either be equal or 40 to 60, etc. Also, the size of contributions can be measured both by the size of your investments or the amount of work you provide.
For example, if your friend has invested a higher sum of money but you work more. So, chances are that your ratio in profits would be equivalent.
Apart from that, a partnership is a lot like a sole proprietorship but instead of being the sole owner of the business, you have a partner.
Your partner would have a predetermined share in the profits and losses of your firm.
How to form a partnership?
Just like a sole proprietorship a partnership is fairly simple to form. The only difference is a partnership agreement.
Having a partnership agreement is crucial to this business structure type. A lot of things can go haywire if you don’t work on pre-decided terms and conditions.
Your partnership agreement would decide your share in profits and losses, the type of partnership you have, and what would happen if you decide to dissolve the partnership in the future.
Types of partnership
A partnership can be of the following types:
- General Partnership: In a general partnership, all the partners have an equivalent stake in the business.
- Limited Partnership: A limited partnership has partners who play the role of an investor and have no say in the functioning of the business.
- Joint Venture: A joint venture is a partnership that exists for a limited period or for certain projects.
The advantages of a partnership can be given as follows:
Easy to form: Just like a sole proprietorship, a partnership is fairly easy to form. And requires a very little amount of legal procedures.
Has more growth potential: As a partnership combines the strengths and talents of all partners, it has more growth potential than a sole proprietorship.
Moving forward without a partnership agreement can be disastrous: You shouldn’t move forward without a proper legal agreement. There are a lot of things that can go awry without one. And coming to terms with an agreement that suits everyone is difficult for a lot of partnerships.
Unlimited liability on your personal assets: Just like a sole proprietorship, there’s an unlimited liability on your personal assets. In such structures, you can lose your personal belongings if your business fails.
Difficulty in dissolution: Dissolution is tougher in partnerships as the business has multiple stakeholders.
Consider the following situation: You want to start a business but have a significant amount of personal belongings that you don’t want to risk.
Then an LLC or a limited liability company might be for you. In an LLC you are taxed only on your profits.
Also, there’s no liability on your personal assets as you and your business are separate legal entities.
An LLC is a fairly new legal structure and is good for industries where lawsuits are common. Moreover, an LLC gets the best of both worlds.
Its tax structure is like a partnership and it has a limited liability structure like a corporation.
Also, unlike a corporation, an LLC can be set up by smaller businesses too.
How to form an LLC?
An LLC is formed by creating a separate legal entity for your business. Although it requires way more paperwork than a sole proprietorship or partnership, it is a more secure structure than either of those.
And you might think that a little paperwork is worth the benefits it provides. And it definitely is! You can form an LLC either on your own or with a partner.
The specific amount of paperwork required for an LLC varies from state to state.
Your personal assets would be safe: One of the major benefits of any limited liability structure is that your personal assets remain unaffected if things go downhill.
The tax structure is beneficial: You are only taxed on your profits in an LLC.
An LLC is tougher to set up: It is comparatively more expensive and complicated to set up. You might have to take some legal advice as well before you set up an LLC.
An LLC has to be dissolved within 30 years: An LLC has to be dissolved in 30 years or less, depending upon your pre-decided agreement. Although, all states have different laws regarding the dissolution of an LLC.
Corporations are one of the most commonly known types of business structures out there. They are usually larger, have more employees, and take the highest amount of legal work to set up.
The biggest advantages of a corporation are its limited liability structure and the tax benefits it gets.
Most of the bigger companies and MNCs follow this structure, but if you have a small business it is neither possible nor feasible to have such a structure. Though, a lot of LLCs and partnerships turn into corporations as they grow bigger.
How to set up a corporation?
Setting up a corporation requires the highest amount of paperwork and legal procedures.
You have to register your business name and get your EIN or employer identification number, etc.
Also, depending upon your state and type of corporation the legal procedure for setting up a corporation would differ.
Types of corporation
A corporation can be divided into the following types depending upon its size and functions:
A C Corp is the most common type of corporation out there. Most MNCs follow this structure.To form a C Corp you collect fundings and give stocks equivalent to the funding to your investors.Although double taxation might be a problem, C Corp has the highest opportunity of getting investments. Hence, most companies follow this structure when they go public.For example, if you are a corporate firm with a large number of employees and investors, you’ll follow this structure.Microsoft, Intel, and Apple are popular examples of C Corps.
An S Corp is a pass-through tax entity and is usually owned by families or small groups.Also, the motive of a C Corp is to grow big and go public, while an S Corp exists to generate profits for its owners. Hence, both the structures fulfill different motives for their owners.An S Corp is very similar to an LLC and is a structure that can be followed by small businesses. A lot of S Corps turn into C Corps as they grow bigger.Apart from that, people choose this structure mainly for the tax benefits it offers.
A B Corp or benefit corporation is the legal structure of a business that stands behind a social cause but is a for-profit organization.
- For example, organization XYZ works towards the social and economic upliftment of underprivileged children. But at the same time, it has investors to whom it has to send back profits. Hence, XYZ organization is not a non-profit but a B Corp.A B Corp is an excellent way of standing behind a social cause and many states provide tax benefits to such structures.Ben & Jerry’s, Seventh Generation, and Etsy are popular B Corps in the US.If we try to understand this further through the example of Ben and Jerry’s, the company has three main motives- product quality, economic reward, and service to the community. Because Ben and Jerry’s is a for-profit company that stands behind a cause it becomes eligible for its B Corp status.
The most limited possible liability: Corporations give the highest amount of protection to your personal assets. If things go awry, your personal assets will be the safest in this structure.
Corporations have a high potential to raise capital: With the option of selling stocks to get funding and more credibility to get loans, raising capital is fairly easy for corporations.
Taxes are filed separately from personal taxes: As taxes are filed separately from personal taxes in corporations your business becomes eligible for corporate tax breaks.
Difficult to set up: Corporations go through way more procedures, legal or otherwise and are fairly difficult to set up. The structure is also not an ideal one for smaller businesses.
Double taxation: You have to pay taxes on both the earnings of the corporation as well as on the dividend you get from it. This disadvantage mainly holds true for a C Corp.
If you want to work towards a social cause and channel all your energies towards it, a non-profit organization would fit the best for you.
The chief difference between any other legal structure and a non-profit is that a non-profit solely exists for fulfilling a social cause and not for earning profit.
Such organizations get tax-exempt status from the government.
As a nonprofit is run for serving society and for personal values, it does not have any advantages or disadvantages as such.
But you should keep the following things in mind before starting a nonprofit organization:
- Your setup will be similar to that of a corporation: You’ll have to register your business’s name as well as your taxation number as a non-profit to get tax exemptions.
- You should have a solid system in place to collect funds: If you choose this business structure, generating funds to keep your firm going will be a chief priority.
In conclusion, the legal structure of a business plan greatly depends upon the said firm’s function and size. The number of legal formalities you are able and willing to fulfill, the laws of the state your business will function from, and so on.
Also, getting legal advice from an attorney while deciding your structure can be of great help for your business. A little expense and effort, in the beginning, can take your business a long way in the future.
Your legal structure would impact a lot of aspects of your business. Hence, you should choose it wisely.