What Is a Business Legal Structure?
A business legal structure, often called a business entity, is a government classification that oversees specific aspects of your business. Federally, it decides your tax obligations, while at the state level, it can affect your liability.
Why Is a Business Legal Structure Important?
Choosing the right business structure from the start is one of the most critical decisions you can make. Here are some factors to consider:
- Taxes: Sole proprietors, partnership owners, and S corporation owners treat their business income as personal income. C corporation income is considered separate from an owner’s personal income. Because of the different tax rates for business and personal incomes, your choice of structure can significantly affect your tax burden.
- Liability: Limited liability company (LLC) structures can shield your personal assets in case of a lawsuit. However, it’s worth noting that the federal government doesn’t recognize LLC structures; they’re only recognized at the state level. C corporations offer liability protection similar to LLCs and are recognized as a federal business structure.
- Paperwork: Each business legal structure comes with its own set of tax forms. If you opt for a corporation, you’ll also need to submit articles of incorporation and regularly file specific government reports. Additionally, if you start a business partnership and operate under a fictitious name, you’ll have to file special paperwork for that too.
- Hierarchy: Corporations are required to have a board of directors, which in some states must meet a certain number of times per year. The corporate hierarchy also provides protection against business closure in scenarios like the transfer of shares, the departure of an owner, or the death of a founder, which other structures may lack.
- Registration: You’ll need a business legal structure to register your business in your state. Without it, you won’t be able to apply for an employer identification number (EIN) or obtain all the necessary licenses and permits.
- Fundraising: Your choice of structure may limit your fundraising options. For instance, sole proprietorships typically can’t offer stocks, as that privilege is mainly reserved for corporations.
- Potential consequences of choosing the wrong structure: Your initial decision on the business structure is critical, even though you can alter it later on. However, changing your structure can be a messy and confusing process, possibly resulting in tax implications and the unintended dissolution of your business.
Types of Business Structures
The most common business entity types are sole proprietorships, partnerships, limited liability companies, corporations, and cooperatives. Here’s a closer look at each type of legal structure.
Sole Proprietorship
A sole proprietorship is the simplest business entity. When you set up a sole proprietorship, one person is responsible for all of the company’s profits and debts.
“If you want to be your own boss and run a business from home without a physical storefront, a sole proprietorship allows you to be in complete control,” said Deborah Sweeney, vice president and general manager of business acquisitions at Deluxe Corp. “This entity doesn’t offer the separation or protection of personal and professional assets, which could prove to be an issue later on as your business grows and more aspects hold you liable.
Proprietorship costs vary by market. Generally, early expenses will include state and federal fees, taxes, business equipment leases, office space, banking fees, and any professional services your business contracts. Some examples of these businesses are freelance writers, tutors, bookkeepers, cleaning service providers, and babysitters.
A sole proprietorship business structure has several advantages.
Easy setup: Setting up a sole proprietorship is the easiest legal structure you can opt for. If you’re the sole owner of your business, this could be the best choice for you. There’s minimal paperwork involved because you don’t have any partners or executive boards to deal with.
Low cost: Costs can vary by state, but generally, the only fees associated with a proprietorship are license fees and business taxes.
Tax deduction: Since you and your business are considered a single entity, you may be eligible for specific tax deductions designed for sole proprietors, such as deductions for health insurance.
Easy exit: Closing down a proprietorship is just as straightforward as starting one. As the sole owner, you can dissolve your business at any time without needing to complete any formal paperwork. For instance, if you run a daycare center and decide to shut it down, you simply need to stop operating the daycare and advertising your services.
The sole proprietorship is also one of the most common legal structures for small businesses. Many well-known companies began as sole proprietorships and eventually evolved into multimillion-dollar enterprises. Here are a few examples:
- eBay
- JCPenney
- Walmart
- Marriott Hotels
Partnership
A partnership involves ownership by two or more individuals and comes in two types: general and limited partnerships. In a general partnership, everything is shared equally among partners, while in a limited partnership, one partner controls operations, and the others contribute to and receive part of the profits. Partnerships can function like sole proprietorships, with no distinction between partners and the business, or as limited liability partnerships (LLPs) depending on the entity’s funding and liability structure.
“This setup is great for anyone looking to venture into business with a family member, friend, or business partner – like running a restaurant or agency together,” says Sweeney. “In a partnership, partners share profits and losses and make decisions jointly within the business structure. Keep in mind that you’ll be liable for decisions and actions made by both yourself and your business partner.
The costs of a general partnership vary, but this structure tends to be more expensive than a sole proprietorship because you’ll likely need an attorney to review your partnership agreement. The attorney’s expertise and location can influence the cost.
A successful business partnership requires a mutually beneficial partnership agreement. Google serves as a prime example. In 1995, Larry Page and Sergey Brin, co-founders of Google, developed a small search engine that eventually became the world’s leading search engine.
The duo met at Stanford University while pursuing their doctorates and later left to create a beta version of their search engine. After securing $1 million in funding from investors, Google began attracting thousands of visitors daily. With a combined ownership stake of 11.4% in Google, Page and Brin now boast a total net worth of nearly $226.4 billion.
Business Partnerships Offer Numerous Benefits.
Easy Formation: Forming a business partnership is relatively straightforward. Similar to a sole proprietorship, there’s minimal paperwork involved. Depending on your state’s requirements, you might need to file for a fictitious name (“doing business as,” or DBA), which entails submitting a Certificate of Conducting Business as Partners and drafting an Articles of Partnership agreement, along with paying additional fees. Additionally, obtaining a business license is usually necessary.
Growth potential: Business partnerships offer potential for growth. With multiple owners, securing a business loan becomes more feasible. Banks consider the credit histories of all partners, which can be advantageous if one partner has a less-than-perfect credit score.
Special taxation: Partnerships also benefit from special taxation rules. While general partnerships file federal tax Form 1065 and state returns, they typically don’t pay income tax at the business level. Instead, partners report their share of income or losses on their individual tax returns. For instance, if you and a friend start a bakery together as a general partnership, each of you contributes certain expertise and capital to the business, which influences your share of ownership. If you’ve invested more capital initially, you might agree to a higher ownership percentage, making you the majority owner.
Partnerships are a popular choice for businesses, and there are numerous successful examples:
- Warner Bros.
- Hewlett-Packard
- Microsoft
- Apple
- Ben & Jerry’s
Limited Liability Company
A limited liability company (LLC) is a flexible business structure offering owners protection from personal liabilities, similar to a corporation, while enjoying the tax benefits and flexibility of a partnership. With an LLC, members are shielded from personal liability for business debts, except in cases of proven negligence or wrongful actions resulting in harm to others during business activities.
“LLCs were designed to give business owners the same liability protection as corporations while allowing earnings and losses to flow through to owners’ personal tax returns,” explained Brian Cairns, CEO of ProStrategix Consulting. “LLCs can have one or more members, and profits and losses don’t necessarily have to be divided equally among them.”
According to Wolters Kluwer, forming an LLC involves paying a state filing fee, which varies depending on your state. For instance, in New York, you’d need to pay a $200 filing fee along with a $9 biennial fee and submit a biennial statement to the New York Department of State.
While LLCs are common among small businesses, they’re also chosen by some larger corporations. This legal structure is prevalent in industries like accounting, tax, and law firms, but it’s adopted by various other types of companies as well. An example of a notable LLC is Anheuser-Busch, a major player in the U.S. beer industry. Based in St. Louis, Anheuser-Busch operates as a wholly owned subsidiary of Anheuser-Busch InBev, a multinational brewing company headquartered in Leuven, Belgium.
Here are some other well-known examples of LLCs:
- Pepsi-Cola
- Sony
- Nike
- Hertz Rent-a-Car
- eBay
- IBM
Corporation
The law sees a corporation as its own entity, separate from its owners, with its own legal rights. It can take legal action, own property, sell stocks, and engage in various other activities. The fees for filing as a corporation can differ based on the state and the type of fee.
There are various types of corporations, such as C corporations, S corporations, B corporations, closed corporations, and nonprofit corporations.
C corporations: These corporations, owned by shareholders, are taxed separately from their owners. For instance, JPMorgan Chase & Co. operates as a C corporation. Companies like Apple, Bank of America, and Amazon opt for this tax status due to its flexibility in accepting numerous investors.
S corporations: Designed with small businesses in mind, S corporations avoid double taxation and offer limited liability protection to owners. Widgets Inc. is a prime example of an S corporation. Here, employee salaries are subject to FICA tax, but additional profits distributed from the corporation do not incur further FICA tax liability.
B corporations: Also known as benefit corporations, B corporations are for-profit entities dedicated to corporate social responsibility. They aim to make a positive impact on society while pursuing profitability. For instance, The Body Shop, a skincare and cosmetics company, has demonstrated its commitment to social and environmental causes and has earned B corporation status.
Closed corporations: These corporations, often managed by a small group of shareholders, are not publicly traded. They enjoy limited liability protection and offer more flexibility compared to publicly traded companies. Hobby Lobby, a privately held, family-owned business, serves as an example of a closed corporation. Stocks associated with Hobby Lobby are not traded publicly but are held by family members.
Open corporations: These corporations are publicly traded on the stock market, allowing anyone to invest. Companies like Microsoft and Ford Motor Co. are examples of open corporations. They offer shares of ownership to the public, providing investment opportunities to individuals.
Nonprofit corporations: Nonprofit organizations operate with the primary goal of serving others rather than generating profits. They are granted tax-exempt status by the government. Examples of nonprofit organizations include the Salvation Army, the American Heart Association, and the American Red Cross. These organizations are dedicated to various charitable causes and community services.
Corporations Enjoy Several Advantages.
Limited liability: Stockholders aren’t personally liable for claims against your corporation; they’re liable only for their personal investments.
Continuity: Corporations aren’t affected by the death or the transferring of shares by their owners. Your business continues to operate indefinitely, which investors, creditors, and consumers prefer.
Capital: It’s much easier to raise large amounts of capital from multiple investors when your business is incorporated.
This setup is perfect for businesses that have progressed beyond the startup phase, unlike a business starting out in a home office. For instance, if you’ve launched a shoe company, named your business, appointed directors, and raised capital through shareholders, the logical move is to incorporate. Essentially, you’re operating at a riskier but potentially more profitable level. Moreover, you might consider filing as an S corporation for tax advantages. When your business reaches a certain stage of growth, it’s usually beneficial to incorporate it.
These are some popular examples of corporations:
- General Motors
- Amazon
- Exxon Mobil Corp.
- Domino’s Pizza
- JPMorgan Chase
Cooperative
A cooperative (co-op) is owned by the same folks it serves. Its offerings benefit the company’s members, also known as user-owners, who have a say in the organization’s mission and direction and share profits.
Cooperatives Offer a Couple of Key Advantages.
- Boosted funding: Cooperatives might qualify for federal grants to aid their initial setup.
- Discounts and superior service: By pooling their resources, cooperatives can secure discounts on goods and services, leading to better deals for their members.
Creating a cooperative is quite involved and involves selecting a business name that reflects whether it’s a corporation (e.g., Inc. or Ltd.). The filing fee for a cooperative agreement differs from state to state.
An exemplary cooperative is CHS Inc., a Fortune 100 enterprise owned by U.S. agricultural cooperatives. As the top agribusiness cooperative in the nation, CHS posted a net income of $422.4 million for the fiscal year 2020. Here are some other noteworthy examples of cooperatives:
- Land O’Lakes
- Navy Federal Credit Union
- Welch’s
- REI
- Ace Hardware
Factors to Consider Before Choosing a Business Structure
For startups that might fit into multiple categories, deciding on the right structure isn’t always straightforward. Think about your business’s financial requirements, level of risk, and growth potential. Changing your legal structure after registering your business can be tough, so it’s crucial to carefully analyze your options early on.
Here are some key factors to consider when choosing your business’s legal structure. It’s also a good idea to seek advice from a CPA.
Flexibility
Consider where you want your company to go and which legal structure can accommodate the growth you envision. Refer to your business plan to assess your goals and determine which structure aligns best with your objectives. Your entity should facilitate growth and adaptability, not hinder it. [Check out this template to learn how to write a business plan.]
Complexity
When it comes to the complexity of starting up and running your business, nothing beats a sole proprietorship. Just register your name, start operating, report your profits, and pay taxes on them as personal income. However, securing external funding can be challenging. On the flip side, partnerships need a signed agreement to outline roles and profit shares. Corporations and LLCs come with various reporting obligations to state and federal authorities.
Liability
In a corporation, you have the least personal liability because the law treats it as its own separate entity. So, if someone sues the corporation, they can’t touch the personal assets of the officers or shareholders. An LLC provides similar protection but also comes with the tax advantages of a sole proprietorship. In partnerships, liability is split among the partners according to the terms of their partnership agreement.
Taxes
An LLC owner pays taxes similar to a sole proprietor: all profits count as personal income and are taxed accordingly at year-end.
“As a small business owner, you want to avoid double taxation in the early stages,” noted Jennifer Friedman, principal at River. “The LLC structure prevents that and ensures you’re taxed as an individual, not as a separate company.
Partners in a partnership also report their share of profits as personal income. Your accountant might advise making quarterly or biannual advance payments to lessen the impact on your return.
A corporation files its own tax returns annually, paying taxes on profits after expenses, including payroll. If you draw a salary from the corporation, you’ll pay personal taxes, like those for Social Security and Medicare, on your individual return.
Control
If you prefer sole or primary control over your business and its operations, a sole proprietorship or an LLC could be the right fit. You can also negotiate similar control in a partnership agreement.
A corporation is designed to have a board of directors responsible for making major decisions that steer the company. While initially, a single person can control a corporation, as it expands, there’s a growing need to operate it as a board-directed entity. Even for a small corporation, rules typically applied to larger organizations, like keeping records of every significant decision impacting the company, still hold.
Capital Investment
If you need to obtain outside funding from an investor, venture capitalist, or bank, you may be better off establishing a corporation. Corporations have an easier time obtaining outside funding than sole proprietorships.
Corporations can sell shares of stock and secure additional funding for growth, while sole proprietors can obtain funds only through their personal accounts, using their personal credit or taking on partners. An LLC can face similar struggles, although, as its own entity, it’s not always necessary for the owner to use their personal credit or assets.
Licenses, Permits, and Regulations
Besides legally registering your business entity, you might need specific licenses and permits to operate. Depending on your business type and activities, you might require licensing at the local, state, and federal levels.
“States have different requirements for various business structures,” Friedman explained. “Depending on your location, there might be distinct requirements at the municipal level too. When selecting your structure, consider the state and industry you’re in. It’s not a ‘one size fits all’ scenario, and businesses may not be aware of what applies to them.
The structures discussed here are applicable only to for-profit businesses. If after your research you’re still uncertain about which business structure suits you best, Friedman suggests consulting with a business law specialist.