How to decide between different legal structures
Sole proprietorships have different implications than LLCs and S corporations. Consider all business structure types before choosing the best one for you.
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Choosing a legal structure for your business is like choosing your home: You pick one based on what's most important to you, and what's right for your goals and plans. And, like a home, with a little work and expense, you can change to a new legal structure when the time is right.
Think carefully about your legal structure because it'll determine your obligation to pay debts on behalf of your business.
The simplest business structure is the sole proprietorship, in which one owner assumes all responsibility for the business — debts as well as profits. It's the default business structure if you're the sole owner and requires no action.
A sole proprietorship isn't an entity per se, but a business operated by a single individual. So there are no government formation fees. A sole proprietorship requires pass-through taxation, meaning tax responsibility is passed on to you as an individual.
But sole proprietorships lack liability protection, so the owner is personally responsible for the business's debts. If the sole proprietor is sued, and there's an unfavorable judgment, his or her personal assets could be at risk.
The partnership entity is similar to the sole proprietorship because it requires no action. But it involves two or more owners who share the business's profits and losses.
Partnerships also require pass-through taxation, so tax responsibility passes onto the partners involved. Partnerships don't require government formation fees either, and do not offer personal liability protection for the owners.
S corporations and standard corporations, also known as C corporations, do offer personal liability protection.
Although these structures are more complex and expensive to create and maintain, they also create independent legal entities completely separate from owners. This can provide greater legal protection for the business owner. S and C corporations can spread ownership by selling stock to shareholders, but must have boards of directors to oversee operations.
These entities have different ownership and taxation requirements. Almost anyone can be an owner of a C corporation, but no more than 100 people can be owners of an S corporation. And a C corporation's profits may be taxed twice: once at the corporate level and then again when distributed as dividends to shareholders. Owners of S corporations avoid taxation at the company level and pay taxes only on dividends and distributions.
LLCs, or limited liability companies, are hybrid entities, combining aspects of partnerships and corporations. They provide limited liability to owners, who share equal authority unless otherwise noted in an operational agreement. LLCs generally have pass-through tax treatment, which means owners pay their shares of the LLC's income taxes.
The last common legal structure is the LLP, or limited liability partnership. Professional service firms are often LLPs. Think lawyers, doctors, and accountants. LLPs provide each general partner with limited liability and pass-through tax treatment.
Which entity you choose will depend on several factors, including your industry, the number of owners involved, and your future growth plans.
If you're starting a medical practice, you might want the professional designation that LLPs offer. Or if you want to save time and start now, you might decide on a sole proprietorship.
Before you choose, reflect on your business goals and consider carefully the liability you want to assume.
You should also consult with an attorney and an accountant. Even booking a one-hour consultation with these experts can help you determine the best route for your business.
And remember: The best legal structure for your business right now might not be the best one down the road. Reevaluate your structure every few years to make sure you're using the best one. Just as your business plan should evolve, your legal structure can grow and change with your business.