Choosing a legal structure for small business entities is a critically important decision that shapes the way a business functions in every manner. These legal structures offer different liability protections, tax codes and what control you have over the business.
There are three structures that small businesses typically choose from when setting up their business. Maximizing advantages that a specific structure can offer is paramount to the long-term success of your business. Below, you will find the main types of legal structure for small businesses as well as the things you should consider when choosing one.
1: Sole Proprietorship
When developing a business structure, a sole proprietorship is the simplest legal structure for small business startups. This is particularly useful if you are an entrepreneur trying new things or have no intention to expand beyond yourself. A sole proprietorship does not differentiate between business and person.
This means that taxes are done on a personal-tax form, and the taxes paid will follow tax laws for an individual. This is not the best form if you have more serious intentions with starting a small business or do not want to assume liabilities and debts on your personal account.
There are general partnerships and limited partnerships. A general partnership shares profits and losses, assumes equal responsibility for a company and an equal right to managing a small business. This means that if things go south with your business partner, one of you cannot bail. Partners file taxes individually and not as a business.
A limited partnership has a limitation on liability. This is a benefit from a legal standpoint because a partner is only responsible for what they contribute to a business. If there are legal or financial issues, then personal assets cannot be seized. Only people with active controls over a business are responsible for it. If someone simply financed a business, then they do not have to deal with potential legal issues.
3: Limited Liability Company
A limited liability company is a common legal structure for small business startups that allows everyone to reap the benefits of taxes under a partnership but not take personal liability. As long as the people underneath the LLC have been ethical, legal and responsible regarding the business, those individuals cannot come under fire or face penalty.
A limited liability company offers substantial benefits for a small business. Legal structure for small business startups can become complicated, but an LLC reduces the complexity. Furthermore, you do not need to have multiple people involved to own an LLC. It can start out with yourself and include more people at a later time.
Benefits and Downsides of an LLC
An LLC is more flexible than an S-Corp. Moreover, S-Corps are not included in this list because they are generally bad news for small businesses. There are limited amounts of owners that can be under an LLC, and an owner can create specific rules for who is treated with what laws and structures.
It does not have to treat all investors equally the way a corporation has to. States have different laws for how an LLC is run. Therefore, it is important to be aware of the laws in your state before deciding on an LLC or LLP.
Tax Structure of an LLC
The tax structure is a self-employment tax. This means that everything that goes through the LLC and into the hands of each owner will be taxed as self-employment income. This can be high depending on circumstances and state taxes. In certain cases, you can register your LLC in a different state or simply move to start a small business.
Choosing a Legal Structure
Garrett Gunderson, a contributor to Forbes magazine, says that choosing the best legal structure for small business startups will improve the odds of your business surviving past the five-year mark. This is because it takes considerable effort to pick the best structure for your business needs. Also, people are often unwilling to do that footwork before opening their startup.
If you know you have no intentions to expand beyond yourself or a single partner, then a sole proprietorship or LLP may be the best choice. If you have a desire to grow with investors and owners, you should look into an LLC. A simple prediction about where you want your small business to go in the future can make the biggest difference.
Legal Liability Considerations
If you make an investment in expensive equipment and materials, you may not want to be responsible for those losses yourself. This simple evaluation can help you decide which legal structure for small business startups you should choose. If your business doesn’t involve special equipment, investments, or sensitive-legal considerations, a more simplistic structure may be suitable.
Taxation is one of the top factors when considering the best forms of business structures. S-Corps have a variety of tax options available. However, this can be overwhelming and often unnecessary unless there has been substantial investment in a startup.
There are long-term costs associated with choosing certain structures. Furthermore, S-Corps have a hefty cost of maintenance if the business does not grow enough to offset those costs. This is another reason an S-Corps is not considered one of the best options to choose. You can change structures later if absolutely necessary. A sole proprietorship and even an LLP require less record keeping and expert advice overall.
Summing It Up
The best legal structure for small business startups is going to be the structure that offers you the most for your overall goals. It can be difficult to switch an incorporation structure later in the life of your business. Still, it can be best to play it safe and choose the simplest option first.
Other considerations include what you want to happen to the business should you need to sell or dissolve it. Every situation is unique. However, choosing a legal structure should be prioritized and taken seriously for the long-term success of any legal structure for small business.