Starting a business comes with many important decisions, one of which is selecting the best legal structure (or entity) for your business.
A business legal structure (or business entity) is a government classification that determines how your business will be taxed and how much liability you can incur.
There are 4 basic types of business structures: Sole Proprietorship, Partnership, Corporation, and Limited Liability Company (LLC).
A Sole Proprietorship is an unincorporated business entity with a single owner. Most businesses are sole proprietorships because it’s the easiest business entity to form — you just start doing business.
- There is no registration with the state.
- You report your profits and losses on your individual tax return; therefore, there is no double taxation.
- You do not need corporate formalities to run the business (e.g., no board of directors, voting on business decisions, annual meetings, or corporate filings).
- You are exposed to unlimited liability because, in the eyes of the law, there is no division between you as an individual and your business. You are personally liable for all the debts and obligations of the business, which means that creditors and claimants can reach both your business and personal assets if needed to settle a debt or lawsuit.
A Partnership (or General Partnership) is an unincorporated business entity with two or more owners. A partnership begins when you decide to do business with another person and agree to share your profits and losses.
- There is no registration with the state.
- There is no double taxation. As with a sole proprietorship, the profits and losses of a partnership are “passed through” to you and your partners on your individual tax returns.
- There are little to no corporate formalities, and each partner is presumed to have an equal share in profits, losses, and decision-making, unless you agree otherwise in a Partnership Agreement (which you should always have). Consequently, partnerships are flexible to operate and able to make swift decisions. The lack of formalities also makes it easy for partners to contribute and return capital, which can take the form of cash, property, or services.
- Each partner is an agent of the partnership. Therefore, one partner can unilaterally enter into agreements that are binding on all partners. This could lead to negative legal and financial consequences if you have the misfortune of selecting an unreliable, negligent, or self-dealing partner.
- Although a partnership is easy to establish and run, each partner is exposed to unlimited liability. Therefore, as a partner, you are personally liable for the debts and obligations of the partnership and for any negligent acts made by your other partner(s).
- Luckily, there are variations to partnership structure, known as Limited Partnerships and Limited Liability Partnerships, that limit the personal liability of one or more partners.
A Corporation is a formal business structure that is a separate legal entity from its owners.
- The legal structure of a corporation offers the strongest liability protection to its owners, known as shareholders, by shielding them from personal liability for the debts and obligations of the corporation, so long as the owners follow the corporate formalities required by the state. Such corporate formalities include but are not limited to holding annual shareholders meetings, voting on business decisions, recording meeting minutes, and submitting timely corporate filings with the state.
- This business structure is ideal for fundraising as you can exchange shares of the corporation (i.e., units of equity ownership) for investments funds.
- A corporation must be registered with the state (“incorporated”), which means that it takes more time, money, and effort to establish and run your business, than if you opted for a sole proprietorship or general partnership.
- You must follow corporate formalities in order to maintain the liability protection (“corporate shield”) of the corporation, which can be burdensome and confusing.
- It is subject to double taxation, meaning the corporation is taxed and the individual shareholders are taxed if they are paid dividends (i.e., a share of the profits of the corporation).
- There is complex management system. A corporation is owned by the shareholders who purchase shares of the company and is managed by a board of directors, who are elected by the shareholders. The board of directors appoint officers (e.g., CEO, CFO, COO) to run the day-to-day operations of the corporation.
A Limited Liability Company (“LLC”) is a formal business structure that is a separate legal entity from its owners.
- An LLC protects its owners from personal liability, so long as the members keep the assets of the LLC separate from their personal assets and comply with minimal corporate formalities.
- There are little corporate formalities required of an LLC, including recordkeeping of major business decisions and filing annual reports with the state.
- You are not subject to double taxation because an LLC is a pass-through entity, by default. You will report the business’s profits and losses on your individual tax return.
- An LLC is flexible to manage. All of the members can manage the LLC, or there can be a group of managing members. Additionally, each LLC member shares equally in the profits, losses, and decision-making of the LLC, unless you agree otherwise in an Operating Agreement.
- An Operating Agreement is not required by the state but is highly recommended if your LLC has more than one owner, as the agreement will clearly set forth the rules governing operations of the LLC and the rights and duties of its members.
- An LLC must be registered with the state (“incorporated”), which can delay the startup of your business.
Overall, an LLC is the best legal structure for most businesses because, like a corporation, an LLC protects its owners from personal liability, but unlike a corporation, has little formalities and is flexible to manage. Furthermore, an LLC is ideal for tax planning as you can elect to be taxed as a sole proprietor, partnership, C-Corp or S-Corp.
Our business law attorneys at Lyons & Associates, P.C. are available to assist you in selecting the best business legal structure for your company. You may contact Crystal L. Lawson by phone at 908-575-9777 or by email at [email protected] to schedule a free consultation. Our offices are conveniently located in Somerville, Morristown, and Freehold, New Jersey.