Business legal structure is a statutory arrangement of a company identified in a jurisdiction and determines the activities it can undertake. This business legal structure differs based on raising capital, responsibility for obligations of the business, and the amount of taxes that the business owes to tax agencies. Therefore, before deciding on the type of business legal structure, enterprise owners should assess their needs and objectives and understand the features of each business structure.
Types of Business Legal Structures
When starting a business, one of your most significant decisions is selecting your company's legal structure. Your legal structure will affect everything from taxes to liability to the paperwork you must file. Understanding the legal business structures available to you is essential to make an informed decision. Below are some prevalent business legal structures you can choose from.
Partnership
A partnership is a business legal structure with two or more owners. It is the most uncomplicated business structure for a company with two or more owners. In addition, a partnership shares many similarities with a sole proprietorship. For instance, the enterprise does not stand as a distinct legal entity from its owners; the owners and the entity are treated as one individual.
In addition, when filing taxes, the losses and profits of the business are handed on to the partners, and each partner must register the details in Form 1065 with their tax returns. Furthermore, partners must pay self-employment tax, depending on their share of the enterprise's earnings. Furthermore, a partnership business structure offers several benefits.
When registering a partnership, negligible paperwork is involved, and the partners are not mandated to fulfill the same prerequisites that limited liability companies are subjected to. Furthermore, partnerships enjoy a certain taxation agreement, where partners must document their share of the earnings or loss of the company on their income tax return. Nevertheless, the partners are personally accountable for the obligations and debts of the business, and their assets can be traded off to settle the business obligations. Also, conflicts may arise between the partners, slowing down the business's operations.
Sole Proprietorship
A sole proprietorship is a business legal structure where a single individual manages the day-to-day operations. Regarding tax obligations, the business's profits and expenses are reported on the owner's tax return.
Since a sole proprietorship is not a distinct legal entity from its owner, the business must not submit separate tax forms. The proprietor must file Form 1040, which includes Schedule C and Schedule SE for self-employment tax. There are numerous benefits to selecting a sole proprietorship business structure. Firstly, starting is a low-cost option, and there are minimal business registration fees. Generally, the only expenses associated with operating a sole proprietorship are business taxes and operational license fees.
Furthermore, business owners can claim tax concessions such as medical insurance. Also, unlike a limited liability company, a sole proprietorship is unnecessary to satisfy ongoing obligations such as holding shareholder meetings, voting, or electing directors. Yet, the major drawback of a sole proprietorship is that the owners will bear personal responsibility for the business's debts, liabilities, and obligations.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a unique business structure that combines elements of both partnerships and corporations, offering owners personal liability protection while reducing tax and business requirements. With a pass-through taxation model, the company's profits and losses are attributed to individual owners, who must include their share of the profits or losses in their tax returns.
Unlike S-corporations, which have a limit of 100 shareholders, there are no restrictions on the number of shareholders in an LLC. Registering an LLC involves filing articles of association with the Secretary of State in the intended state of business and, in some cases, submitting an operating agreement.
One of the significant advantages of establishing an LLC is that it has fewer requirements than corporations, requiring less paperwork while providing owners with limited liability protection that safeguards their assets from being used to settle the entity's liabilities. Additionally, LLCs have no limits on the number of shareholders they can appoint. However, forming an LLC can be expensive, as it must be registered with the state where it plans to operate. Moreover, LLCs may need to hire professionals like accountants and attorneys to ensure compliance with regulatory and tax requirements.
Corporation
A corporation is a popular business structure that separates the entity from its owners, giving it a distinct legal identity. However, setting up a corporation can be complex and costly, often requiring legal assistance to navigate the registration process and comply with state laws. In addition, incorporation is necessary for businesses planning to go public and issue common stock.
Moreover, corporations are subject to federal and state taxes, and shareholders must report dividend payments on their income taxes. C-corporations and S-corporations are the two primary categories of corporations. C-corporations function as independent legal entities, while S-corporations function similarly to partnerships and can have up to 100 shareholders.
One of the key benefits of a corporation is the ability to raise capital by selling shares of stock to the public. Additionally, the corporate structure provides limited personal liability, protecting owners from business debts and obligations. However, corporations face additional requirements, including meeting and voting requirements and electing directors, which can increase costs compared to sole proprietorships or partnerships.
How to Choose a Business Legal Structure
Selecting the most appropriate business structure can seem like a daunting task. Still, it is a critical decision that can significantly impact your business's growth, financing opportunities, and tax obligations in the future. Below are the factors to consider when choosing a business legal structure.
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Ease of Setup
One of the practical factors to consider is the ease of setup. Different business structures require varying degrees of legal and bureaucratic processes to establish. For instance, registering as a sole trader is relatively straightforward and inexpensive compared to incorporating as a limited company, which involves additional paperwork and fees.
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Administrative Load, Legal Prerequisites & Scrutiny
Another crucial consideration is the administrative load, legal requirements, and scrutiny involved. Some business structures are scrutinized and have more legal and administrative responsibilities than others. For example, directors of incorporated businesses must file annual accounts and submit financial reports to the public domain. Limited companies must maintain detailed records of their activities and undergo annual audits, while partnerships must file additional tax returns.
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Personal Liability and Risk
Personal liability and risk are also important factors. Considering the different levels of personal risk involved in various business structures is vital. As a sole trader or in a partnership, your business has no separate legal identity, making you personally responsible for any losses or debts that your business incurs. In contrast, limited liability partnerships and limited companies create a distinct legal entity for the business, reducing your liability.
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Scalability of Your Business
Scalability is another critical factor to consider. While you may be in the early stages of your business, it is wise to think about the impact of your business structure on scalability in the future. For example, registering as a sole trader may limit your credibility and access to funding, making it difficult to secure loans or attract investors.
Limited companies or limited liability partnerships may have better financing and investment opportunities. You can offer stock as collateral for loans and retain the ability to buy and sell that stock. However, incorporating as a limited company may dilute your control over the business since you must appoint a board of directors.
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Key Terms for Business Legal Structures
- Partnership: A business owned and run by two or more individuals who share in the earnings and losses of the business. Partnerships may be general, where all partners share in the management of the business and are personally liable for its debts, or limited, where one or more partners are passive investors and have limited liability.
- Corporation: A business entity that is legally separate from its owners. Corporations can issue stocks and have shareholders who own a portion of the company. They also have limited liability protection for their owners.
- Limited Liability Company (LLC): A business structure that combines the benefits of a corporation with those of a partnership or sole proprietorship. Owners of an LLC are not personally liable for the company's debts and obligations.
Final Thoughts on Business Legal Structures
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