Determining Your Business Legal Structure

A plan of action is needed to fulfill the goal of being your own boss and running a successful business.  Success lies in the approach you choose to take.  This article will help you with facts regarding legal requirements and what lies ahead regarding your business legal structure.

The pattern is fairly well established.  Once an entrepreneur has determined the goods or services the company will offer and whether there is a market for the product, a decision must be made on the type of business formation.  Typically, your will choose to be a sole proprietorship, a partnership, a limited liability company (LLC), or a corporation.  There’s no right or wrong choice that fits everyone.  Your job is to understand the advantages and disadvantages of each business legal structure and pick the one that best meets your needs.  The best choice is not always obvious.  We recommend you consult an attorney to provide more detailed advice.

In evaluating the different structures there are several key issues to be considered:

• control
• liability and
• Tax implications.

Make certain you ask and answer:

• Your vision regarding the size and nature of your business.
• The level of control you want.
• The level of “structure” you are willing to deal with.
• The business’ vulnerability to lawsuits.
• Tax implications of the different ownership structures.
• Expected profit (or loss) of the business.
• Whether or not you need to re-invest earnings into the business.
• Your need for access to cash out of the business for yourself.

Selecting Your Business Legal Structure

Sole Proprietorship

The majority of all small businesses begin as Sole Proprietorships.  These firms are owned by one person, usually the individual who has day-to-day responsibility for running the business.  Sole proprietors own all the assets of the business and the profits generated by it.  They also assume complete responsibility for any of its liabilities or debts.  In the eyes of the law and the public, you are one in the same with the business.  Currently used by more than 75 percent of all businesses, it is often the suggested way for a new business that does not carry great personal liability risks.  The owner simply needs to secure the necessary licenses, tax identification numbers, and certifications in his or her name and you are now in business.

Major advantages that differentiate the sole proprietorship from the other forms of business legal structure include:

1. The ease with which it can be started;
2. The owner’s freedom to make decisions and;
3. The distribution of profits (owner takes all).

Partnerships

Business Partnership, two or more people share ownership of a single business.  Like sole proprietorships, the laws do not distinguish between the business and its owners.  It is extremely important partners have a legal agreement that sets forth how decisions will be made, profits shared, disputes resolved, how future partners will be admitted to the partnership, how partners can be bought out, and what steps will be taken to dissolve the partnership when needed.  It’s difficult to think about a “break-up” when a business is just getting started, but many partnerships split up at crisis times and unless there is a defined process in place, there will be problems that could have been easily avoided.  At the outset, partners must decide up-front how much time and capital each will contribute.

General Partnership

Partners divide responsibility for management and liability, as well as the shares of profit or loss according to their internal agreement.  Equal shares are assumed unless a written agreement states differently.

Limited Partnership

Limited Partnership and Partnership with limited liability.  “Limited” means most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short term projects, or for investing in capital assets.  This form of ownership is not often used for operating retail or service businesses.

Corporate Structures

Corporation

A corporation chartered by the state, in which it is headquartered, is considered by law to be a unique entity, separate and apart from those who own it.  A corporation can be taxed; it can be sued; it can enter into contractual agreements.  The owners of a corporation are its shareholders.  The shareholders elect a board of directors to oversee major policies and decisions.  A corporation has a life of its own and does not dissolve when ownership changes.

Advantages

• Shareholders have limited liability for the corporation’s debts or judgments against the corporation.
• Generally, shareholders can only be held accountable for their investment in stock of the company (note: officers, however, can be held personally liable for their actions, for example, officers could be liable for the failure to withhold and pay employment taxes).
• Corporations can raise additional funds through the sale of stock.
• A corporation may deduct the cost of benefits it provides to officers and employees.
• When forming a corporation shareholders can elect S Corporation status if certain requirements are met.  This election enables company to be taxed similar to a partnership.

Disadvantages of a Corporation

• The process of incorporation requires more time and money than other forms of organization.
• Corporations are monitored by federal, state and some local agencies, and as a result, may have more paperwork to comply with regulations.
• Incorporating may result in higher overall taxes.  Dividends paid to shareholders are not a deductible form of business income, thus, dividend income can be taxed twice.

Subchapter S Corporation

Selecting Subchapter S Corporation status is a tax election only.  This election, when applicable, enables the shareholder to treat the company’s earnings and profits as distributions.  They pass through directly to the shareholder’s personal tax return.  The catch here is that the shareholder, if working for the company, and if there is a profit, must pay him or herself wages and it must meet standards of “reasonable compensation.”  This can vary by geographical region as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit.  If you do not do this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for all of the payroll taxes on the total amount.  As you can see, advice from a lawyer and or accountant is often invaluable when structuring your entity.

Limited Liability Company (LLC)

The LLC is a relatively new type of hybrid business structure that is now permissible in most states.  It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.  The formation of a LLC is more complex and formal than that of a general partnership.

The owners are members, and the duration of the LLC is usually determined when the organization papers are filed.  The time limit can be extended if desired by a vote of the members at the time of expiration.  LLC’s must not have more than two of the four characteristics that define corporations:

1. Limited liability to the extent of assets;
2. continuity of life;
3. centralization of management; and
4. free transferability of ownership interests.

Comparison of Subchapter S Corporation and LLC

LLC and Subchapter S are both corporate structures in the United States that allow pass-through taxation.  The main differences between a Subchapter S Corp. and LLC are:

• S corporations are more restrictive on who the shareholders (owners) of the company can be.
• S corporations are required to pay a salary to those owners who work for the company and own more than 2% of the company.  In contrast, LLCs are not obligated to pay a salary to its members (owners).  This has tax implications for some companies.
• S corporations are required to maintain and file formal records for the board and shareholder meetings.
• S corporations are allowed to have only one class of stock.
• It is a little easier to set up employee stock option plans for S corporations than for LLCs.

Professional Corporation

Owners have no personal liability for malpractice of other owners in the corporation.  More expensive to create than a partnership or sole proprietorship.  Paperwork can seem burdensome to some owners.  All owners must belong to the same profession.  Professional corporations are typically used by doctors, lawyers and psychologists

Nonprofit Corporation

Nonprofit corporations do not pay income taxes.  Contributions to charitable corporations are typically tax deductible.  Fringe benefits can be deducted as business expenses.  Full tax advantages available only to groups organized for charitable, scientific, educational, literary, or religious purposes.  Property transferred to a nonprofit corporation stays within this sphere; if the nonprofit corporation ends, the property must be passed on to another nonprofit.

Choosing Your Entity’s Legal Structure

The business legal structure you choose depends on a number of things, including your type of business, individual situation, goals for the business, and a number of other personal and financial factors.  Before deciding what’s best for you, discuss your plans with your accountant and attorney.  Make sure you are prepared to describe your business plans in some detail.  It will be money and time well spent.  Making the right choice can help you avoid a mistake that can cost you in possible future liability.

Before you have any discussions with your professional advisors, it is useful to understand the basics of the various business legal structures available to you.  In addtion, you need to consider some aspects that can be as important as the determination of the business legal structure.  Here are just a few:

• Is there an agreement that outlines responsibilities, ownership, contributiuons of the participants?
  • What happens if the entity is sold, one of the members leaves or dies, or there are new fianncial requirements?
• When and how much salary will be paid and are they expenses or changes in capital contributions?
• When the business shows a profit, how and when will the profit be divided or dividends paid?

Other Legal requirements

You need to register your business regardless of form.  Most counties have a clerk’s office where you can register your name and obtain a trade certificate.  The clerk’s office will issue a trade certificate or a partnership certificate after verifying that the name of your business is not already in use.  There is usually a small fee associated with it and the clerk’s office will usually give you a few copies which are for yourself, the state and your bank.

A CERTIFICATION OF INCORPORATION must be filed with the Secretary of State.  These forms should be written by a lawyer as they are very complex and require professional expertise in their preparation.

If you intend to start a business that will sell to the consumer, you must register for a Sales Tax Number at the office of Department of Taxation and Finance.  If you purchase supplies or products to be used in the production of a product to be sold retail the Sales Tax Number will help you avoid paying sales tax to your supplier by signing a tax waiver form and giving it to your supplier.

For information regarding Federal or State government contracts, foreign markets, expansion, technical assistance in financial planning and management, call your state tax organization.

Many businesses require a license, such as plumbers, electricians, real estate brokers, hair dressers, ticket agencies, private investigators, etc.  To find out whether or not you need to get one, call the Office of Business Permits and Regulatory Assistance.

Legal issues are a pain and are often put off in the early stages of a startup.  Make sure you don’t make this mistake.  Take care of these issues as soon as you.  When addressed early on, they can be easily dealt with thus, solving tax, operational and ownership issues of the entity.

Rule One:  Owners must understand and decide the right structure for their entity.  Once they make their decision, they must execute the proper paperwork to allow them to carry out their decisions.  As the business becomes live, these issues will typically become second nature.

Legal resources and sources

Small Business Legal Resources (http://www.nolo.com)

“Nolo” is a commercial site but offers good, plain English explanations on just about any legal topic in which you are likely to have an interest; LLC’s and other business structures, patents, copyrights, hiring, termination, wills and estates, etc. Use this site to help inform you on the basics.  We would suggest, however, seeking professional legal help before proceeding on any of those.

Legal Zoom (www.legalzoom.com)

Legal Zoom provides an easy-to-use, online service that helps people create their own legal documents.  They brought together some of the best minds in the legal and technological fields to make this vision a reality.  Legal Zoom is a great resource for forms and information.  However many attorneys argue you also need the legal advice to understand the technicalities and relate to your needs.