One of the most important decisions that every business owner needs to make is deciding which legal structure to adopt. You have to understand that how you structure your business carries tax and compliance implications.

There are a number of factors you need to consider in order to determine the right type of business structure for your company. It should help you maximize deductions, decrease personal liability, and enable your business to grow at a steady rate. To help you choose the best legal structure for your company, we’ll look at the available options. Let’s jump in.

1. Sole Proprietor

One of the legal structures that you can adopt is a sole proprietorship. It is common for people to first start their business journey as sole proprietors. You would have to use your personal social security number initially until you obtain a taxpayer identification number for the company by filing the IRS SS-4 form.

You will make a request to the IRS to provide you with an employer identification number. The business would operate under your name. However, you do have the option to seek an alternative name by registering for a Doing Business As (DBA) designation. This will allow you to get a different name for your business. You will have to comply with specific rules depending on the state you reside in. Moreover, you might need to apply for a business trademark as well.

The main reason why individuals decide to run their business as a sole proprietor is that they have to file their taxes together on their business and personal income. This ensures minimal paperwork and less hassle. Besides, people who are freelancing part time or are fully employed, can become sole proprietors. However, it is important to keep in mind that it does not provide corporate protection (corporate liability protection). For this reason, your personal assets would be at risk if you are sued or the business goes bankrupt.

This happens because there is no legal difference between personal and business assets with this business legal structure. Hence, your personal assets would need to be sold in order to pay debtors.

2. Partnership

Another type of legal structure that your business can opt for is a partnership. A partnership is a form of business that is owned by more than one person. You can either form a general partnership or a limited partnership. A general partnership is where both profit and loss are shared equally. On the other hand, a limited partnership is where only one partner contributes and receives part of the profits, whereas the other partner controls the operations. When there is no separation between the business and the partners, it is possible to operate the business as sole proprietors. However, limited liability partnerships provide a liability structure.

Partnerships are suitable for anyone who is going into business with their family member, business partner, or friend. Some great examples include an agency and a restaurant. The partners get to make business decisions regarding business activities, and your business plan together and also share profits and losses.

However, you would be held liable for the decisions made by your business partner. You should also know that this structure costs more money than a sole proprietorship as it would require an attorney to review the partnership agreement.

Both sides have to agree to the business partnership agreement. A great example of a business partnership that you should know about is Google which was co-founded by Sergey Brin and Larry Page in 1995. What began as a small search engine ended up taking over the world.

There are plenty of reasons a partnership might be the best structure for your business. A partnership is relatively easy to form, as there is little paperwork involved. You might need to adopt a fictitious name and file a certificate for conducting business as partners. Moreover, an article of partnership agreement is an absolute must. You will also have to obtain a license depending on the type of product or service you provide.

A great thing about running a partnership is that it makes it easier for you to seek a business loan. The reason behind this is that the bank prefers two credit histories instead of just one. What’s more, you will have to file a federal tax form 1065 as well as state returns. Then, you and your partner will need to report the shared income or business losses when filing your income tax return.

Partnerships are popular as each owner brings working capital and a certain type of experience to the business. If you invest more capital into the partnership, you and your partner can decide that you will receive a higher percentage when it comes to profit and loss. Hence, you would be the majority owner of the organization. Some successful partnerships that you should know about include Apple, Microsoft, Hewlett-Packard, Warner Bros, and Twitter.

3. Limited Liability Company (LLC)

A limited liability company is formed to protect owners from business-related liabilities. This type of structure has been popular ever since its inception. Its simplicity and strong legal protection make it worth considering for many individuals. If you want to protect your personal assets, you should consider forming a limited liability company. It takes a sole proprietorship to the next level.

You will appreciate the fact that it is quite simple to set up and does not cost a great deal of money. There is less paperwork and you get to benefit from legal protections from court judgments and non-guaranteed debts, even though your company would not be considered a separate entity.

Having legal protections in place makes all the difference, and removes a considerable amount of stress from your life. However, if you make a personal guarantee on a debt, it would become a part of the contract and your personal funds would be at risk. This means that the corporate veil would be exposed and you could be held personally liable. Moreover, you will need to operate the business as a separate entity in order to retain its value. As for the earnings made, they would be subject to self-employment taxes. You might also need to pay an additional franchise tax depending on the state you operate in. Make sure to consult the federal government’s IRS website, your state’s tax site, and your accountant, to better understand your personal tax burden and all tax implications for your business.

4. S Corp

A subchapter S Corporation or S Corp, is a type of business structure designed by the IRS to enable an organization to be recognized as a unique entity. This means that it is considered a separate entity from the person who owns it. Because of this separation, you would benefit from limited legal liability. As there would be a separation between personal and business assets, you will enjoy peace of mind and greater financial safety for you and your family.

What you will need to do is file separate tax returns for the organization. Form 1120S is normally filed. As profit and losses pass to the shareholder, the business does not get taxed. Instead, only the shareholders of the company are taxed. Moreover, if a shareholder works for the company, he or she can receive reasonable compensation for running the company. A fair market value must be paid to the shareholders for their work. Otherwise, the IRS would reclassify additional corporate income as wages and the S Corp would have to pay employment tax which includes Medicare taxes and Social Security.

Generally, an S Corp is mostly suitable for people who would pay themselves a low wage in order to avoid having to pay self-employment tax. Furthermore, the company can be audited from time to time and penalties might need to be paid if there are violations.

5. C Corp

A C Corporation or C Corp is also a great option for independent professionals as it allows you to become a shareholder. You get to have the same status as any other Fortune 500 business. A C Corp is a separate entity from its owner. When you individually own the C Corp, you would be the majority shareholder. Although the structure might be more complex, it is more sophisticated and attractive for independent business owners.

The IRS views C Corps as individual taxpayers. As the company would have limited liability, you will not be held personally liable for anything. Moreover, fringe benefit deductions are also offered, such as health reimbursement arrangements. A C Corp is subject to double taxation, which is something that you need to take into account. It’s good to gain a clear understanding of how your legal structure decisions affect tax treatment within your business so you can stay compliant, plan ahead, and continue to do business.

Conclusion

Different legal structures offer certain tax benefits, legal advantages, corporate and individual protections, and organizational advantages. It’s a good idea to do plenty of research in to each one, and seek advice from a good lawyer and an accountant so you can make the very best decision for yourself and your organization. 

Sound Accounts helps business owners get organized, stay compliant, and make the most of their finances, with individually tailored bookkeeping service plans and ongoing advice. Contact us today to learn more and find out how to qualify for 6 months of free QuickBooks. 

To learn more about business legal structures, check out our frequently asked questions below. 

 

FAQ

 

What is the best legal structure for my business?

When it comes to selecting a legal structure for your business, you have to think about several factors – what kind of business you want to run, how you want to split up profits and liabilities, how much protection you want against legal ramifications, whether you want shareholders or to keep it entirely private, and much more. It’s good to consult an attorney and a financial professional for clarity and direction.

Why is it important to choose the right legal structure for your business?

The specific legal structure of your business affects many things, your taxes, how profits and responsibilities are divided, how much exposure you have to legal liabilities, whether stockholders are involved, and more. Your legal structure says a lot about who and what you are as a business, and allows you to function more successfully within your goals. It can also protect you from unnecessary penalties or the possibility of personal losses should problems arise. 

Why is a Limited Liability Company (LLC) a good idea for many businesses?

The main reason why limited liability is crucial for a business owner is that it ensures you are not held personally liable for certain court judgements and non-guaranteed debt incurred by the company.