Choosing the best legal structure for your business
Starting a business involves making a number of tough decisions. What to name your company, where to operate, who to hire, what paperwork to file and how to score investors, just to name a few. Out of all these determining the best legal structure for your organization may be the most important. Many business owners leave the task waiting too long. After all, it’s a complex decision that involves considering a variety of factors such as taxes, personal liability limitations, transferability and investor expectations.
It doesn’t help that there are quite a few options out there. Do you select an S-corporation? A C-corp? Do you head for sole proprietorship, or pick partnership? To help make the process a little easier, here are four business structures to consider:
This is the simplest and most common for of business organization. The founder only needs to apply for the specific licenses that allow them to conduct business in their jurisdiction. Company owners are able to use their own social security numbers, and do not need to apply for a federal taxpayer identification number. Tax reporting is done through Schedule C and is attached to the founder’s annual tax return. Quick and easy, sole proprietorship gives the owner complete managerial authority.
Of course, that also means that the sole proprietor is 100 percent liable for all the company’s debts and obligations. Has your business taken out a loan, or has been sued? Suddenly your personal assets are at risk and can be seized. It is also impossible for a sole proprietor to transfer interest in her company and remain in the same legal position. Alex Katz, a CFO and partner at ff Venture Capital, writes on Entrepreneur: “In my view, the risk here far outweighs the benefit, and I almost never urge a founder to start her business as a sole proprietorship.”
There are two types of partnerships. The first, general partnership, is another easy to form structure, which once again provides no liability protection for partners. Limited partnership, on the other hand, protects LPs from debt liability. However, it can complicate taxes and be very difficult to operate. Limited partnerships require a general partner who will be personally liable for all debts, meaning that someone always gets the short end of the stick.
Corporations: Good news: corporations can protect founders against liabilities. There are two corporation types that are defined by how they are taxed. S-corporations do not pay federal corporate income tax. Instead, profits and losses are reported on shareholder tax returns. S-corps can only have up to 99 shareholders — and there are restrictions to the type of shareholders allowed — and only one class of stock. C-corporations are slightly more flexible. C-corps are allowed an unlimited number of shareholders and any number of stock classes, while still limiting founder liability. At the same time, C-corps are tax-paying entities and there may be cases of double taxation, first on corporate profit, and then on shareholder dividends. Still, there are many benefits of incorporating, and Katz recommends this structure to most.
A limited liability company, or LLC, is a hybrid structure. It protects founder and partner assets while avoiding double taxation. It is taxed as a partnership, which allows for more flexibility than a corporation. For businesses that do not intend to seek venture capital, an LLC can be the best choice to make. However, many investors may not put money into an LLC due to the Employee Retirement Income Security Act (ERISA). It prohibits certain funds (like pensions) from investing in LLCs.
These are just a few of the many structures available to new business owners, each with their own pros and cons. When your company is finally ready to get off its feet, contact a register agent service and learn more about how to incorporate.