One of the first things you need to decide when establishing a business is what type of legal structure you’ll use. Although you can change the structure later, it’s beneficial to make the right choice for your situation in the present moment, as this will impact everything from the taxes you’ll pay and your liability to the chance to have a partner, investors, and employees. There are seven main types of legal structures for businesses, each of which comes with its own set of advantages and disadvantages.
1. Sole Proprietorship
If you start your business on your own — without a partner or employees — you’ll automatically have a sole proprietorship. There’s no need to pay anything to register your business and there is no paperwork to file, beyond any necessary licenses and permits. You’ll have full control over your business and the company will be indistinct from you for legal purposes. This also means it is easy to dissolve the business, without the need to take any official action, if you decide your venture is not working out.
However, the downside to a sole proprietorship is that you are liable in the case someone sues your business. Plus, your personal assets are on the line if you owe creditors. You’ll also need to pay self-employment tax on all your sales, commissions, and other earnings. Finally, it’s more difficult to raise money for your venture when you’re a sole proprietorship than with other types of legal structures.
When to Choose a Sole Proprietorship
- The business consists of just one person.
- You want to set up a company immediately, without the need for registration.
- It makes sense for you and the business to be the same legal entity.
2. General Partnership
In the case you are starting the business with someone else, you’ll need to opt for a partnership rather than a sole proprietorship. The more common type is a general partnership, where the partners manage the company together, sharing all the responsibilities and profits equally. Typically, your partner will be a family member, friend, or someone you worked with in the past.
To form a partnership, you need to register your business and provide it with an official name. It is important to make sure you have all your legal documentation in order, including a partnership tax return. In other words, unlike a sole proprietorship, setting up a general partnership does come incur some costs. However, all this is relatively simple. You should also note that you’ll be more likely to be accepted for a business loan if you have a partner than if you’re running the business alone.
When to Choose a Partnership
- There are two or more of you looking to establish a business.
- You want the possibility of a business loan.
- You’d still like to limit registration requirements.
3. Limited Partnership
Less common than a general partnership is a limited partnership. In addition to having general partners who run the business, this type of structure includes limited partners who are just investors. These limited partners have no decision-making rights, but they also have no responsibility for liabilities.
Typically, business owners choose a limited partnership if they have an expectation of interest from passive investors. If this is unlikely to apply to your business, a general partnership is a better choice, since there is much less paperwork involved.
When to Choose a Limited Partnership
- Passive investors are interested in your business.
- Personal liability is not an issue.
- You want to reduce taxes on your income.
One of the more complex legal structures is a corporation. It may seem intimidating to set up a corporation. However, most companies with multiple employees are corporations — not least because of the liability protection they gain and the separation of business assets from their own assets. It’s also easier to raise money as a corporation than with many other business structures. For instance, you can sell stock, which means you are less reliant on individual investors.
It’s important to be aware that there are various types of corporations:
- C corporation — A business owned by shareholders and taxed as a separate entity. Many large businesses use this structure.
- S corporation — Created for small businesses. There’s no double taxation, but owners must pay themselves a reasonable salary.
- B corporation — “B” stands for benefit. Although these corporations are for-profit organizations, their purpose is to have a positive effect on society.
- Open corporation — Companies available for trade on the public markets.
- Closed corporation — A privately-held corporation run by just a few shareholders.
If you are only just establishing your business, it will likely be better to wait some time before forming a corporation. Setting up a corporation requires much more paperwork than the other options and will cost you unnecessarily if you are a small business operating fully online. Plus, establishing a corporation requires legal support to ensure you’re complying with relevant regulations and an accountant to help you with taxes — both of which differ according to state.
When to Choose a Corporation
- The business is already established.
- You hire employees.
- You want to sell shares in your company.
4. Limited Liability Company
A limited liability company (LLC) has qualities of both a partnership and a corporation. Your personal assets are protected, but there is no double taxation. Just as your startup is developing into a small business is the perfect time to become an LLC.
You can set up an LLC if it’s only you at the company, if you have a partner, or even if you have employees. Plus, if you do have a partner, there’s no requirement to divide the profits and losses equally between you. However, you should be aware that the operational costs and filing fees can be high — this depends on the state. Some states even have additional taxes for LLCs. If you intend to become a corporation at a later date, though, this could be an excellent move.
When to Choose a Limited Liability Company
- You want to avoid putting your personal assets at risk.
- You want to avoid double taxation.
- The business is a partnership and you want extra legal protection or more flexibility.
Becoming a nonprofit allows you to be exempt from taxes. However, you need to adhere to specific regulations to become a nonprofit. Most importantly, all of your income must pay for expenses related to a charitable cause.
There are a large number of different types of nonprofits, ranging from labor unions and chambers of commerce to cemeteries and social and recreational clubs. All have a different 501(c) code with the IRS. Another way to categorize them is into nonprofit organizations (NPOs) and not-for-profit organizations (NFPOs). NPOs serve a public good and NFPOs serve just their members.
When to Choose a Non-Profit
- The business has a charitable purpose.
- You will not be keeping any of the profits.
- You want to receive tax-exempt status.
Finally, there are cooperatives, or co-ops. These are owned by members of the organization, all of whom also use the services — they are sometimes called user-owners. Members vote about the direction the company will take and share profits.
Co-ops have lower taxes than some other types of legal structures, as you don’t pay tax on your income. Most co-ops have a physical presence, although online co-ops are starting to crop up. Although you are unable to have external stakeholders with a co-op, you may be able to receive federal grants to bring your idea to fruition.
The main disadvantages of co-ops include that they are complex to set up and that you need to meet specific criteria. For instance, businesses must create their own bylaws, have a board of directors who hold charter meetings, and develop a membership application.
When to Choose a Co-op
- There are people interested in becoming members.
- You are happy to split your profits among the members.
- You don’t need external stakeholders.
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