by Chris SwiecickiChoosing a Legal Ownership Structure for a New Business
In the early stages of a business, a lot is riding on every decision. Choosing the legal ownership structure, for example, can impact taxes, legal liability, and the business’s day-to-day operations.
While it is possible to change the structure of a business after setting it up, that can involve unnecessary hassle. It is better to understand the pros and cons of each structure and its implications now and in the future—and start out with the most beneficial formation.
Choices For the Structure of a Business
Deciding on a legal ownership structure involves thinking about the business’s goals and potential future events. For example, an individual planning to sell homemade goods at farmer’s markets for a little extra cash does not need the same business designation as a multi-million dollar manufacturing company.
In general, a less formal structure will have few requirements to meet and straightforward everyday management. More formal structures typically offer tax advantages and personal protections but also have more rules to follow.
The structure of a business needs to be chosen before the owner can apply for a tax ID number, register it with the state, or obtain any licenses or permits. Let’s look at the definitions and considerations for the possible designations a business might pick.
Sole Proprietorship
A person can become a sole proprietor simply by deciding to go into business for oneself. They do not have to file any paperwork or register the business in any way, but instead can simply begin selling goods or providing services.
Because the person is the business, revenue and expenses are recorded on the individual’s income tax return. Sole proprietors may choose a dba (doing business as) and open a separate bank account in that business name to keep things separate from their personal finances, but it is not required.
The main drawback for sole proprietors is they assume all liability. This means that any debts or legal trouble can put their personal assets at risk.
A sole proprietorship works well for someone selling crafts on Etsy or mowing lawns. The risk of someone suing these entrepreneurs is low. For other individuals, such as a childcare provider or the owner of a food truck, the possibility of an accident or other mishap could land them in court. Those businesses would receive more protection from another legal ownership structure, such as an LLC (limited liability company) which we discuss below.
Partnership
If a business fits the description of a sole proprietorship, but there is more than one owner, they may choose a general partnership as the legal ownership structure. Like a sole proprietor, all revenues pass through to the partners and must be reported on their individual tax returns.
General partnerships do not need to be formally registered unless the state requires paperwork to use a business name. But this structure does require a good deal of trust between owners. For this reason, every partnership, even a family business, should have a partnership agreement to make sure everyone is on the same page. This contract will spell out matters such as the division of profits and losses, who has decision-making authority, how conflicts will be resolved, conditions for ending the partnership, etc.
Since general partners assume unlimited personal liability for something the business or the other partner does, an LLP (limited liability partnership) may be preferable. This protects partners from being completely responsible for their partner’s actions. In most cases, the amount of liability is limited by the partner’s contribution to the partnership rather than any personal assets. The articles of partnership will spell this out and may also restrict the amount of operational control of some partners.
A good example of an LLP is a pair of attorneys or dentists practicing together. Both names may be on the door, and the partners may share day-to-day decision-making in the office. But neither is responsible if the other partner is sued.
Limited Liability Company (LLC)
An LLC’s main purpose is to shield its members from legal liability. LLCs can have one owner or several. For an individual whose business has a higher risk of legal action, this legal ownership structure is preferable to a sole proprietorship. An example would be someone making a product that could potentially harm someone, or in an industry where it might face a challenge for patent infringement. The LLC, not the individual, will take legal and financial responsibility for any mishaps.
Starting an LLC means registering the business entity with the Secretary of State. Because it holds business assets separate from the personal assets of its members, there must be meticulous record-keeping to keep revenue and expenses separate too.
That said, an LLC is still a pass-through corporation and does not need a tax return of its own. Each member is required to report their earnings from the company on their tax returns. They are also considered self-employed and must also pay self-employment tax which goes toward Medicare and Social Security.
Individual entrepreneurs and large companies may both benefit from the protections of an LLC. One thing to consider, however, is owning multiple LLCs. Receiving income from several pass-through entities can create a tax burden that is greater than if the legal ownership structure was a corporation.
Image by Bearinmind by Canva.com
Corporation
A corporation can be a C corp or an S corp. Both provide the strongest protection of its owners’ personal assets. Corporations are legal entities that are completely separate from their owners. As such, the company earns profits or suffers losses and files a corporate tax return. Profits are distributed to shareholders in the form of dividends.
A C corp is subject to “double taxation,” because the company pays taxes on its profits, and the shareholders pay taxes on their dividends. This can be avoided by forming an S corp instead, which allows profits to pass through to shareholders without paying a corporate tax. Companies must meet certain IRS requirements to become an S Corp, however.
There are many rules that corporations must follow. Setting one up requires articles of incorporation, a board of directors, annual shareholder meetings, and strict record-keeping and reporting. But there are many benefits as well. Corporations can sell stock and raise capital, and shareholders can sell their shares without affecting the corporate structure.
Forming a corporation is beneficial to large companies with plans to grow exponentially, go public, or to be the subject of a merger or acquisition in the future. But it can be an appropriate structure for a small business too depending on the circumstances.
Which Legal Ownership Structure is Right for You?
In choosing the structure of a business, there are several aspects of the business and its owners to consider.
Protecting Personal Assets. For an individual owner in a business where there is little risk of lawsuits or bankruptcy, a sole proprietorship is usually sufficient. But only LLCs, corporations, and some partnerships protect personal assets from liability.
Control and Management. If day-to-day decisions for company operations are shared, a business should at the very least have a partnership agreement. Forming a corporation with articles of incorporation will formalize the details for larger, more complex companies.
Tax Implications. There is nothing wrong with a corporate structure with pass-through income unless the applicable tax rate results in a huge tax burden. A tax attorney can weigh the pros and cons of pass-through vs. a corporation’s double taxation.
Funding and Capital. If selling stock and raising capital is part of the current or future business plan, a corporation is the best structure option.
Scalability and Flexibility. Big plans for the future, such as expanding to a new region or launching an IPO should be considered before deciding on a legal ownership structure.
Legal Requirements. If an LLC’s protections are sufficient, it doesn’t make sense to form a corporation and jump through all the hoops required with incorporation. Similarly, an individual with a low-risk business does not necessarily need to fill out the paperwork to become an LLC.
Legal Advice for a New Business
The decisions you make about the legal ownership structure of your new business can have a huge impact on its future. The best way to determine the appropriate structure is to discuss it with a business attorney like Swiecicki & Muskett.
Chris Swiecicki’s diverse experience helps identify each business’s unique needs when it comes to business law and taxation. Contact him today to discuss what will be best—and most profitable—for you.