How to Choose a New Business Legal Structure

The legal process for setting up a new business can seem daunting. I needed a refresher course when we started Meetify, even after having been a co-owner on most the legal entity types mentioned in this article, minus an S-Corp.

You don't have to own a business or be thinking about starting one to be curious about what people are talking about when they use words like LLC, sole proprietorship and C-Corp. After doing research for Meetify, here’s the crash course I wish I'd had about the most common legal structures of businesses.

Of course, if you are launching a company, this should only be a start to your research. Make sure to get legal help from a small business attorney and advice from a tax accountant.

Sole Proprietorship:

A sole proprietorship is the simplest business structure to start with legally. You don’t need to incorporate the business, though it’s important to check with your state’s Secretary of State to see if there are any licenses or registrations you need to comply with local and state laws. You won’t need to file business taxes separately from your personal taxes since all the income, expenses and taxes for your business will run through you as a sole proprietor.

However, there will be more complexity to your personal taxes since you’ll be self-employed. Since you’ll be your own employer, you’ll be responsible for self-employment taxes, including social security, Medicare taxes, federal unemployment (FUTA) and income tax. You may also have additional taxes to pay for the business, like excise taxes. If you don’t already have a tax accountant, now is the time to consult with one.

In addition, as a sole proprietor, it’s important to understand that you can be personally held liable for any legal issues that might come up with the business. If you provide services under a name besides your own, you’ll also need to file a fictitious name to protect the business name in your state. Most of these steps are not time consuming, and with minimal costs and professional counsel, you can get up and running quickly.

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General Partnership

A partnership is most like a sole proprietorship but with more than one person who holds ownership in the business. Like a sole proprietorship, the partners are considered self-employed and pay taxes as individuals, rather than as a business entity. They are also not provided with legal protection personally for what takes place in the business. This can be a deterrent for people who might be comfortable without legal protection if they were the only one running the business but who are wary of taking on legal risk for the decisions and actions of someone else. There is such a thing as a limited liability partnership that can provide protection from debts against the partnership and the actions of other partners. This, of course, brings with it more legal complexity.

Similar advantages to sole proprietorships exist for general partnerships as well. They tend to be less expensive and easier to set up from a legal standpoint. However, because they involve multiple people, partners should have a legal partnership agreement that stipulates how things like capital contributions, management responsibilities, banking, dividends and losses, and dissolving or selling the partnership will be handled. An advantage that comes with a partnership is that it can be easier to raise some funding for it as opposed to a sole proprietorship since it’s easier to add additional owners to a partnership that already exists.

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Limited Liability Company (LLC):

If the idea of having some separation between your personal and business worlds sounds appealing to you, an LLC might be the best option for your business. As the name suggests, a limited liability company protects you from having personal liability in most instances with your business. It’s also a way for business partners to work together, while still being able to avoid a more complex company structure, and an LLC can have some tax advantages over a corporation.

In terms of liability, your personal assets will be protected if something goes wrong in the business and assets are required to pay debts or other liabilities. This can provide peace of mind that the risk of starting a business won’t impact more of your personal assets than you’re willing to invest.

An LLC is also a good option for partners who want to avoid the hassle and expense of setting up articles of incorporation and a board, plus having to have board meetings and record major decisions. Still, it would be wise to put in writing what the process will be for buying, selling or transferring ownership at the beginning of an LLC between partners.

One of the more significant reasons business owners decide to set up an LLC is for tax purposes. In a way, an LLC is like a sole proprietorship in that the owner(s) are still considered self-employed and will be responsible for self-employment taxes. The profits from the company will also be split between the LLC owners at the end of the year and the profits will be taxed at each owner’s income tax rate. The advantage is that the LLC won’t also have to pay a corporate tax in addition to the personal income tax on the profits.

Another advantage is that the assets in the business are owned by the LLC owner(s), rather than the business. Therefore, if the owners decide to sell any IP or other assets, they can do so as owners of those assets. In a corporation, the assets are owned by the business and don’t transfer as easily to the owners.

While these reasons may be enough for many owners to choose to form an LLC for their business, there are some disadvantages of an LLC to consider. First, hiring employees can be complicated for an LLC since everyone who is legally part of the LLC is an owner and is considered self-employed. While it’s possible to have people do work for an LLC without having any ownership in it, they are considered contractors, not employees or owners. That means they will also be considered self-employed and will have to pay self-employment taxes and miss out on the benefits that W2 employees enjoy. This could make hiring long term talent more difficult and costly.

Another major consideration is the Qualified Small Business Stock that’s available for non-service related C corporations in industries like technology, retail, manufacturing and wholesale. There are a number of restrictions to understand, but for C corporation owners who qualify for the QSBS, there is a tax exclusion upon the sale of the company that allows those who can get it to avoid the capital gains tax on the sale up to $10 million or 10 times the adjusted basis of the investment when the owner(s) sell their stock, provided they held it for at least five years. Depending on the value of the stock when it is sold, this favorable tax treatment could considerably outweigh the tax benefits of an LLC. Again, all of this should be discussed with a tax accountant and attorney before you set up your company structure.

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Corporation (C-Corp and S-Corp):

C-Corp:

If the disadvantages of a sole proprietorship and LLC seem significant to you, then a C-Corp might be the right fit. For entrepreneurs who plan to seek institutional investors, a C-Corp is the most common legal structure. Both for the way taxes work for investors as well as the oversight that comes from having a board and consistent board meetings, the C-Corp tends to be highly favored by many venture capitalists looking to invest in a company. If a VC leads a round, meaning they are the biggest investor in that raise, they will often get a seat on the board. This can be helpful for you as a founder if the investor or others at the firm have experience growing companies like yours and can lend their wisdom. If having less responsibility for all of the business decisions sounds good to you, this is another reason a C-Corp could be ideal.

In terms of liability, you as the owner are protected from losing more money than you invest in the corporation, just as with an LLC. Unlike an LLC, though, with a C-Corp you can hire W2 employees. In fact, you can even be a W2 employee at the company. While you may or may not consider it a big perk to avoid paying self-employment taxes on your personal taxes, after all, your company will still be responsible for those taxes, it’s certain that those who work for the company will be glad to avoid self-employment taxes. As a W2 employee, you will still pay income taxes on your salary, benefits, bonuses and dividends as will all other W2 employees. Overall, having the flexibility to bring on contractors and W2 employees makes hiring and retention much easier. You also have the option of not taking a salary and paying out dividends to yourself and other shareholders instead, which can help you avoid a higher tax rate. This is a good subject to discuss with your tax accountant who will be able to help you consider your specific situation and all of the variables.

Probably the best tax consideration for those who launch a C-Corp is the Qualified Small Business Stock. For those who qualify for it, it could provide a considerable tax savings down the road. But before you get too excited, the worst tax issue with owning a C-Corp is that the business will pay corporate income tax on business profits. That’s in addition to the personal income tax that owners will pay on their income and any dividends from the profits. This double taxation is a reason many business owners decide to avoid incorporating.

Again, since there are a number of tax considerations that go into making the decision on the best legal structure for your company, a tax accountant or lawyer who is familiar with small business tax law will be invaluable to you.

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S-Corp

An S-Corp is very similar to a C-Corp except for the way it is taxed and its class of stock. The reason I wouldn’t consider it a fifth type of business structure is because a company has to register as a C-Corp or LLC and then file with the IRS to get S-Corp status. The S-Corp avoids the double taxation that a C-Corp is subjected to since the IRS allows the profits and some losses on an S-Corp to pass through to the owners’ personal income without being subject to corporate taxes.

A potential drawback is that there can’t be different types of shareholder stock in an S-Corp. All shareholders receive the same common stock. Depending on the state the company is registered in, it may also be required to pay a franchise tax as well.