When you start a business, choosing the appropriate legal structure is one of the first (and probably most crucial) steps.
Whether you’re just a startup or a growing business, it’s important to understand what kind of options you have. But first, what is a legal structure, and why is it important for businesses of all sizes?
Depending on the legal structure you choose for your business, your tax liabilities will vary. Aside from that, the structure also determines your personal liabilities in case your business faces lawsuits and demands. Additionally, it decides how frequently your board of directors should do paperwork.
If you need help regarding your business legal structure, you might want to visit Swyft or explore document filing services in your area. You can let these third-party companies handle all your paperwork while you focus on setting up and growing your business.
What Are The Factors You Have To Consider When Choosing A Legal Structure?
Below are some of the most important factors you need to consider when choosing the right legal structure for your business. Also, you may consider consulting a certified public accountant (CPA) to help you better understand each factor.
- Ownership Structure
First, you need to consider the number of owners your business has and their involvement in your company’s day-to-day operations. If you’re the only owner of the business, you can choose to be a sole proprietorship, a corporation, or a single-member limited liability corporation (LLC). But if you have a business partner, you may consider forming a partnership, corporation, or an LLC.
However, keep in mind that having more owners can lead to a more complex decision-making process. This makes a corporation or an LLC a much better option than partnerships. Nevertheless, if your business has more than 100 owners, you won’t be able to use the tax status of an S corporation.
When it comes to ownership structure, an LLC is the most flexible. Owners under this legal structure may be involved in the company’s day-to-day operations. But it also allows owners to designate managers who can run the business while others will only serve as investors.
- Financing And Investing Needs
The financing and investing needs of your business may impact the legal structure you can establish. For example, if you want to start a business through bank loans, you’ll notice that most banks are more likely going to grant loan requests from a corporation or an LLC over partnerships and sole proprietorships.
In addition, a corporation might be your best option if you’re looking forward to working with investors. Unlike other business entities, a corporate structure enables businesses to buy and sell shares within the company through stock offerings. This makes attracting investors much easier. Hiring and retaining top employees is also possible when you offer them employee stock options.
However, forming a corporate entity may not be a good option for businesses that have no plans on ‘going public’ nor intentions of issuing stock options. If that’s the case, you may choose an LLC instead. It offers the same protection as a corporation, but its simplicity and flexibility make it a better option.
- Expenses And Formalities
Partnerships and sole proprietorships are easier to establish compared to an LLC and a corporation. There’s no need for you to file additional documents or pay extra fees to start running your business. In addition, there’s no need for you to follow additional operating rules.
On the other hand, an LLC and corporation are often the most expensive to form and challenging to maintain. To establish a corporation or LLC, you must submit certain documents to your state and pay the corresponding fee. This may range from USD$40 to USD$800, depending on your state.
Aside from that, corporations and LLCs have to elect company officials—usually, secretary, vice president, and president—to run and manage the company. Also, they must ensure proper documentation of critical business decisions for formality purposes.
If you’re starting a business with a tight budget, your best option would be the simplest types—sole proprietorships and partnerships. Unless it’s a risky business, the limited liability protection offered by corporations and LLCs may not be worth the paperwork and expenses required to establish and manage one.
- Potential Risks And Liabilities
For the most part, the legal structure best suited for your business highly depends on the products and services you offer. If you’re planning to engage in risky operations, such as repairing roofing or trading stocks, you want to create a business entity that offers limited liability protection. This will help protect your personal assets from business claims and debts. In this regard, the best option to consider would be an LLC or a corporation.
- Income Taxes
Sole proprietorships, LLCs, and partnerships all pay taxes based on business profits in a similar manner. These three are called ‘pass-through’ tax entities, meaning all losses and profits pass through the company to the owners.
Owners of these entities must settle their income taxes based on the company’s net profit. Even if all profits are stored in a checking account to address upcoming company expenses, owners must still report their shares from the profits as income when filing their tax returns.
However, according to the Tax Cuts and Jobs Act, owners of pass-through entities may be entitled to deduct their net income of up to 20%. This reduces the tax rate of their business down to 80%.
On the other hand, the owners of a corporation are not required to report their shares as a part of their personal income tax. The taxes they only need to report and pay are the profits given to them in the form of dividends, bonuses, and salaries.
However, the corporation must pay its own taxes for all the profits left in the company every year—this is called retained earnings. According to the Tax Cuts and Job Act, corporations have a flat tax rate of 21%, which replaces the old rate of 15 to 35%.
Whatever legal structure you choose for your business, you can always change it later on. Initially, you may start as a sole proprietorship or partnership. Later, when your business grows and expands, you can convert your business into an LLC or corporation. If you need more help understanding this complex topic, don’t hesitate to consult a CPA or lawyer to get things started.