How to Determine the Legal Structure of Your Business
Choosing the right legal structure for your business can protect your personal assets if your business is sued. It can also save you money on your taxes.
Basically, there are two broad types of business structures: those that offer their owners limited liability, and those that do not.
In limited liability entities such as corporations, limited partnerships and limited liability companies, the business has a separate legal existence from its owners. The owners’ liability for business debts and obligations is limited to the amount they invested in the business. The owners’ personal assets such as houses, cars and personal bank accounts are not at risk. Owners will, however, always remain personally liable for their own negligence or other wrongdoing.
Other businesses, such as sole proprietorships and general partnerships, do not exist separately from their owners. The owners are personally liable for all of the firm’s obligations. A business that hasn’t formed a limited liability entity will by default be considered a sole proprietorship or general partnership.
To form a limited liability entity, you must file formation documents with the state. Most small businesses file these documents in the state where their business is located, but companies sometimes file formation documents in a different state, such as Delaware, to take advantage of its corporation-friendly laws. A business lawyer can advise you on where to form your business.
Typically, a business must select a name that is distinct from other entity names in the state, pay a filing fee, and name a person or entity to act as registered agent to receive notices and service of lawsuits or other court documents. The exact information required in formation documents varies from state to state.
No matter which business entity you choose, you should have an internal agreement that specifies such things as the rights and contributions of the owners, their rights to share in company profits, how the business will be managed, the procedures if an owner dies or leaves the business, and the procedures for dissolving the business. Hiring a business attorney to prepare an agreement when you form your business can avoid costly disputes later on. Depending on where you live and the type of business you form, this agreement might be called a partnership agreement, an operating agreement or bylaws.
Let's look at some of the possible business entity options.
Sole Proprietorship & Partnership
A person who is the sole owner of a business can operate as a sole proprietorship. No paperwork is necessary to establish a sole proprietorship, but if your business is operating under a name other than the sole proprietor’s name (such as “Joe’s Coffee” or “Intrepid Designs”) you may need to file documents with the state to establish a fictitious business name, trade name, or dba. Sole proprietors report their business income on Schedule C of their personal income tax returns.
Sole proprietors remain personally liable for all of the law firm’s losses and liabilities. In addition, they can be personally liable for the actions their employees take in the scope of their employment.
A partnership works the same way as a sole proprietorship except that there are two or more partners instead of one. Partnerships prepare a partnership tax return and the partners then report their share of the partnership income or loss on their personal tax returns.
A limited partnership differs from a general partnership in that it has both general partners and “limited partners” who act as investors: the limited partners do not participate in running the company and whose liability is limited to the amount they invested.
Partnerships are generally regarded as undesirable because each general partner is liable not only for the debts and obligations of the partnership, but also for any negligence or misdeeds of any of the other partners. You can avoid this by forming a limited liability entity.
Limited Liability Company
A limited liability company, or LLC, is a legal entity distinct from its owners. An LLC combines limited liability with the pass-through taxation afforded sole proprietorships and partnerships. In many states, LLCs are easy to set up, offer flexible management and ownership options, and have fewer ongoing reporting requirements than corporations. The owners of an LLC are called “members,” and an LLC can have one or many members.
If you are a licensed professional such as an attorney, doctor or architect, you state’s laws may require you to form a Professional Limited Liability Company, or PLLC, instead of an LLC. You may be required to obtain approval from your state licensing board before forming a PLLC. A PLLC has the same limited liability and tax treatment as an LLC.
Limited Liability Partnership
A limited liability partnership is, as the name implies, a partnership that offers limited liability for its partners. Setting up a limited liability partnership may be as simple as filing an additional form with the state after establishing a general partnership.
Corporation or Professional Corporation
Corporations are also limited liability entities. In some states, a corporation formed by licensed professionals may be called a “professional corporation” or a “professional services corporation” to distinguish it from other types of corporations. Owners of corporations are called shareholders and enjoy several key benefits:
- Owner-employees can participate in and enjoy tax deductions for company-paid benefit plans, including health insurance and retirement plans.
- Shareholder liability for corporate obligations is limited to the shareholders’ investment in the company. Individual shareholders are shielded from personal liability for other shareholders’ or employees’ wrongdoing.
- A corporation may be eligible for flexible tax treatment. By default, corporations are Subchapter C Corporations for federal income tax purposes. A C corporation files its own tax return and pays corporate taxes on its profit. If profits are distributed to the owners, the owners then pay personal income tax on those distributions. To avoid this double taxation, some corporations can elect to be taxed as a Subchapter S corporation. S-Corps aren’t taxed at the corporate level: the corporation’s income passes through to the shareholders’ personal tax returns, just as it does in an LLC or partnership. The shareholders then pay personal income tax on the corporation’s income. An S corporation must have 100 or fewer shareholders and meet other requirements.
What about the New Tax Law that Took Effect in 2018?
The Tax Cuts and Jobs Act of 2017 made some major changes to the way businesses are taxed at the federal level, including these:
- Pass-through businesses, including sole proprietorships, partnerships, LLCs and S corporations, can deduct up to 20 percent of their profits on their federal return, subject to certain restrictions and limitations.
- Businesses taxed as C corporations will pay a flat 21 percent federal tax rate, instead of the previous graduated rate of 15-39 percent.
These changes could affect whether your business should choose to be a pass-through business or a C corporation. It’s always best to consult an accountant about your specific situation.
A small business attorney can advise you of the best type of entity for your business, can handle filings with the state, and can draft an internal operating document and any resolutions that you might need.