How to Choose a Business Structure
- Lesson Materials Business Legal Terms
- Completion time About 25 minutes
Deciding which legal structure is right for your business model is crucial to your business' success, as it influences how your business operates and grows. Now that you have an idea of the business structures out there, it's time to understand what factors you need to look at specifically when comparing options.
Below, we break down each important factor and how it affects your business.
Depending on which legal structure you select, forming the business could be a breeze – or time consuming with a lot of legal paperwork. The ease of business formation is dependent on who you're going into business with.
If you’re forming the business on your own, formation difficulty is low. If you select a LLC, LP, or LLP, you can expect to have a lengthier formation filled with paper work because there are legal and state guidelines you need to work out.
Ownership obviously alludes to who owns the business; but more importantly, who shares in profits and losses? When it comes to choosing your business legal structure, ownership answers the following questions:
- Who is liable?
- Who is being taxed?
- What happens to your business in the event that the owner dies?
It's also important to have a clear understanding of who actually manages your business. For instance, a sole proprietor has full control of management and operations. However, a Corporation is managed by directors who are elected by shareholders.
As mentioned above, the ownership you select outlines the level of liability exposure; that means assigning who or what is legally liable for the company and its actions. If you select a legal structure that makes you liable, you are responsible for the following:
- All the business's debts
- Employees’ actions or injuries
- Partners' actions
This can be scary. For instance, if your partner makes a deal without your knowledge, and the deal is a bust – you (the innocent party) would still be accountable for paying off debt owed in the deal.
To limit liabilities, most entrepreneurs select LLC, LP or LLP legal structures. However, if your business isn't at risk for liabilities such as employee injury or accidents, a sole proprietor or general partnership would be worth considering.
Legal structure is a huge determining factor in defining what taxes are paid and who pays them. For instance, here's a breakdown of how taxation differs for three legal structures:
- Sole proprietor: The IRS doesn’t identify the business as a taxable entity. As a result, the owner pays all taxes.
- General partnership: The IRS does’nt identify the business as a taxable entity. Each partner pays taxes on their share of income and can deduct losses against other sources of income.
- S Corporation: Taxed as a pass-through entity, meaning the profits and losses are not taxed at the corporate level. Instead, shareholders report their earnings on their individual tax returns.
We go into more detail on each business structure's tax implications in Lesson 3.
Investments refer to how much you have invested in the business. This becomes most important in terms of liability. For instance, if you exceed the assets of your business and are the sole proprietor, creditors can claim your personal assets – that could include your home, car, or even savings account. But if you structure your business as a C corporation, you are not personally responsible for the business' debts.
In addition, investment needs are important to consider for attracting employees and investors. For instance, corporate structures allow a business to sell ownership shares in the company through stock offerings. This makes it easier to attract investment capital and to hire and retain employees by offering employee stock options.
To review, as you compare the legal structures, keep the following points in mind:
- Formation: how easy will it be to form your business?
- Ownership: how much control will you have over your business?
- Liability: how much legal responsibility will you have over the business, your partners, and employees?
- Tax implications: who will pay and how will your business be taxed?
- Investments: how much are you investing and how much are you getting in return?
Rememeber, the legal structure you choose guides your business operation – how your business will be taxed, what liabilities you're responsible for, and what state and federal laws you need to abide by. By the end of this course, you should have a good understanding of which legal structure meets your criteria for all the following points above.
- Lesson Materials Business Legal Terms