If you didn’t get the advice of a lawyer when you started your business or if you’ve experienced changes since you started your business, it’s a good idea to consult with a lawyer to ensure that your business is organized in the correct legal form.
Using the correct legal form can protect you and your assets from your business’ debts and liabilities. If there’s more than one owner of your business, you need to properly document the relationship among the different owners.
There are four structures that are typically used by small businesses – sole proprietorships, partnerships, limited liability companies, and corporations.
A sole proprietorship is not a separate legal business entity and results automatically when you engage in business activity but don’t register or form a legal business entity. The assets and liabilities of your business are not separate from your personal assets and liabilities. As a result, you can be held personally liable for the debts and liabilities of your business, including liabilities from lawsuits against your business.
While operating a business as a sole proprietorship is the easiest way to start with little to no legal formalities, operating a business of any significant size or operations as a sole proprietorship is risky because of the risk to your personal assets. You may also have a harder time raising money or selling the business as banks and investors tend to prefer investing in or lending to a separate legal entity.
The income or loss from a sole proprietorship business is not taxed separately and is directly attributed to the owner, who reports the income or loss on their personal tax returns.
A partnership in its simplest form is automatically created when two or more people start a business. In this way, a partnership is similar to a sole proprietorship with the same disadvantages. Many states offer the ability to form limited partnerships or limited liability partnerships. Limited partnerships require at least one general partner, who manages or operates the business and has unlimited liability for the operations of the partnership.
Limited partners can contribute capital to the partnership and share in its income or loss, but can’t participate in the operations of the partnership.
Except for managing partners, who manage the limited liability partnership and are liable for the actions of the limited liability partnership, partners in a limited liability partnerships are generally legally responsible only for their own actions and not those of the other partners. Limited liability partnerships are generally used by professional partnerships such as law firms or accounting firms. Some states specifically limit the use of limited liability partnerships to certain professions.
The income or loss of partnerships is not taxed separately and is directly attributed to the partners, who report the income or loss on their personal tax returns.
A corporation is a legal entity separate from its owners, known as stockholders or shareholders. Corporations are formed by filing articles of incorporation or a certificate of incorporation with a state or U.S. territory. These filed articles or certificates are one of the governing documents of a corporation that set out terms of how the corporation will be established.
These terms include the types and amount of common stock or preferred stock that the corporation may issue and what say the shareholders will have in the management of the corporation. A corporation also needs to adopt bylaws, which contain additional terms of how the corporation will be governed and have a board of directors to oversee management of the corporation. Directors are required to meet or approve by unanimous written consent certain actions of the corporation. Shareholders of private corporations often enter into another legal agreement, known as a shareholder or investor agreement, which governs the relationship among the shareholders and the corporation. These agreements often include terms limiting when and how a shareholder can sell their stock or what types of information the corporation is required to give to the shareholders. Due to these formalities, using a corporation is more complicated, time intensive, and costly than other types of legal entities such as a limited liability company.
The benefit of forming a corporation to run your business is that it is a separate legally entity and its shareholders cannot be held liable for the actions of the corporation. Each shareholder can only lose the amount of their investment. This is an advantage over sole proprietorships or partnerships, but similar to limited liability companies. Corporations can raise capital from existing or new shareholders by selling new common or preferred stock.
Corporations are further distinguished by how they are taxed.
Also known as c-corps, the income of the corporation is directly taxed and any dividends paid to shareholders are taxed again as dividend income.
Also known as s-corps, the corporation is disregarded for tax purposes and income or loss of the corporation is directly attributed to each shareholder in proportion to their ownership. S-corps avoid the double taxation of c-corporations and are the preferred tax election for small and medium-sized businesses.
A corporation makes an election to be a C-corp or S-corp by filing with the U.S. Internal Revenue Service. Most states treat S-corporations the same as the IRS, but there are some states that don’t directly attribute the income or loss directly to the shareholders. The IRS imposes some limits on the use of S-corporations, such as prohibiting other partnerships or corporations from being shareholders, permitting only one class of stock and allowing no more than 100 shareholders.
A limited liability company (or LLC) is a legal entity separate from its owners, typically known as members. Limited liability companies are formed by filing articles of formation or a certificate of formation with a state or U.S. territory. This document contains a limited amount of information about the LLC such as its name, purpose and sometimes, its initial members. An LLC can have one or more members and raises capital by selling interests in the LLC to its members.
LLCs can either be member managed or manager managed. Some or all of the members of a member-managed LLC run the day-to-day operations of the LLC. In a manager-managed LLC, the members do not participate in the day-to-day operations of the LLC. Instead, managers of the LLC are appointed by the member to run the business.
The terms of how the LLC will be governed (e.g., who will run the LLC, how major decisions will be made, how income and loss will be attributed governance of an LLC and the relationships among members) are contained in the LLC’s operating agreement. An LLC’s operating agreement can range from very simple for a single member LLC to very complex for multi-member LLCs. Most all states permit great flexibility in how an LLC is governed and operated. For example, certain members could have a priority on cash distributions, requiring them to get their capital back and a set return before other members receive any distributions, or members can each have more or less control over the operations of the LLC. Operating agreements often contain provisions limiting when and how a member can sell their interests.
LLCs do not have to observe all of the formalities of corporations. A board of directors is not required (although an LLC can choose to have one), state filings are usually simpler or not required, and formal board of directors meetings or consents are not required. It’s typically cheaper and simpler to operate a business in an LLC.
Like a corporation, the benefit of forming an LLC to run your business is that it is a separate legally entity and its members cannot be held liable for the actions of the corporation. Each member can only lose the amount of their investment. This is an advantage over sole proprietorships or partnerships. LLCs can raise capital from existing or new members by selling new common or preferred stock.
LLCs with a single member are disregarded for tax purposes by the IRS and states. This means they are treated like a sole proprietorship for tax purposes and the income and loss of the LLC is directly attributed to the single member. An LLC with two or more members can elect with the IRS how it will be treated for tax purposes. It can elect to be treated as a partnership, an S-corporation or a C-corporation. Most multi-member LLCs elect to be treated as a partnership to avoid the double taxation of a C-corporation.
Members of an LLC are treated as self-employed and must pay self-employment tax for Medicare and Social Security on all of the distributions from the LLC. Owners of an S-corporation can be employed by the S-corporation and receive a reasonable salary for their services, upon which Medicare and Social Security taxes are due, but dividends from an S-corporation are not subject to these taxes.
Every business is unique, and this article doesn’t address all of the pros and cons of each structure or their requirements and limitations. It’s important to seek the advice of a lawyer and a tax adviser if you haven’t in the past. The downsides to choosing the wrong structure can be significant. You can lose your personal assets to satisfy the debts or other liabilities of your business if you’re a sole proprietorship or a partnership. A judgment in a lawsuit could wipe out both your business and your personal assets if you are personally liable. Or you can be paying more taxes than necessary. Regardless of how your business is organized, you should always make sure that you have the appropriate type and amount of insurance. See our article Quick Guide to Business Insurance: How to Protect Your Business for information about how to review your insurance coverages.
If your business has changed significantly since you first formed it, you may want to consult with a lawyer to ensure that these changes don’t impact how you are organized. These changes could include bringing in additional owners, having owners exit the business or you’re in need of external capital.
You can move your business into different structures at any time, although there could be tax implications of doing so. It’s important to consult also with your tax adviser before taking any actions.
This article is provided by NEWITY LLC for educational and informational purposes only and is not intended and should not be construed as legal advice.