Starting a new business is an exciting proposition, but it’s fraught with tension too. Many questions must be answered before your fledgling business gets off the ground. One of the first has to do with the legal structure of the company, also known as a business entity. What types of legal structures exist? What are the advantages and disadvantages of each? And how do you decide which one is right for the new business you have in mind?
Every entrepreneur must answer these questions before moving bringing their vision into reality. Adams Accounting Solutions has coached many business owners through the process of choosing the proper legal structure for their new business venture. Yes, there are tax implications involved in the decision. But other factors come into play, as well.
Why Does the Legal Structure Matter?
It’s essential to choose your legal structure wisely when setting up your business. How you structure it impacts your tax rates, legal liability, paperwork requirements, and fundraising ability. It also affects the extent to which your personal finances are tied to the business. While it is possible to change the structure after the company is up and running, the process usually involves lots of paperwork and may leave you open to unintended tax consequences or even the accidental dissolution of the business.
Types of Business Structures
There are five common business structures.
#1. Sole proprietorship. A sole proprietorship is the easiest structure to set up. It’s also the default structure. If you engage in business activities without registering as any other type of business entity, you’re automatically considered a sole proprietorship.
In a sole proprietorship, you are your business. Your personal and business assets have no barrier between them. This can be confusing because revenue coming in tends to get mixed with personal funds if no record-keeping system exists. You can also be held personally liable for the debts and obligations of the business in a sole proprietorship. If the business gets sued, your personal assets may be in danger.
#2. Partnership. A partnership is a company owned by two or more entities. There are two types of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).
In a limited partnership, only one person has unlimited liability, while the rest of the partners are limited. The owners with limited liability also tend to have limited participation in the daily operations and interests of the company.
A limited partnership limits the liability of all owners. No partner is liable for the actions of any other partner. This may be a good solution if you’re starting a business with a buddy.
#3. Limited liability corporation (LLC). An LLC is a hybrid structure that provides the tax benefits and flow-through earnings of a corporation while limiting owners’ personal liability in the event of a lawsuit. Partners’ personal assets are shielded from liability, and income is taxed at the lower individual rate rather than the corporate rate. Owners in an LLC are considered self-employed and have to pay Medicare, Social Security, and self-employment taxes on their own.
#4. Corporation. A corporation is an entity that’s separate from its owners. It operates independently, earning revenues, paying taxes, and being held legally liable for anything that happens in the name of the business. Forming a corporation provides the most protection when it comes to personal liability, but there are many rules that go along with setting up a corporate structure. Setting up a corporation is also quite expensive, which makes this structure less appealing to first-time business owners.
There are several corporate structures, each with nuances you should be aware of before filing any paperwork. Check with your CPA if you’re thinking of setting up a corporation. They can help you work through the differences in corporate structures.
#5. Cooperative. A cooperative may be a good fit if the business will be owned and operated by the people using its services. Members become part of the cooperative by purchasing shares in it and receive some benefit from being a member, for instance, lower pricing on products or services.
Still Wondering What’s Right for You?
Choosing the appropriate legal structure for your new business is a critical decision that will impact the success of your business for years to come. If you still have questions about which legal structure is right for you, call Adams Accounting Solutions. We’re happy to help you sort through the pros and cons of each as it relates to your new business venture!
