Your legal structure - How to choose from an alphabet of choices

Written By Tim Richard

S-corp. LLC. LP,  LLP,  LLLP. There's a seemingly endless choice of letter combinations when it comes to the legal structure of your business. What do they all mean? Moreover, what are the implications for your organization? At what point do you choose? And how do you make a decision?

Two main considerations

1. A primary reason to create a business entity is to limit your personal responsibility for business liabilities and debts.  Some business types, such as corporations, will protect some of your personal assets, but no business structure pardons you from all debts if your business is not profitable.
   
   Banks, lenders and landlords usually require personal guaranties for startup loans or lines of credit-regardless of your business type. In the end, you may not be personally liable to vendors or other creditors, but you will be liable to the bank that helped finance your business.
   

2. Taxation is the other primary issue in choosing your business type. Most allow you to "pass through" income for your taxes, which is usually what small businesses want.

Following is an overview of the most common business entities used by small businesses and a few basic characteristics of each.

Sole Proprietorship: 

Definition

The simplest and most common way people do business. Rather than forming a separate legal entity, the business is the individual owner. This type of business is often registered simply as a business trade name or a "d/b/a" (doing business as) name for marketing purposes. 

Characteristics

• Business income and expenses are reported on your personal tax return using a separate schedule. The downside; as a business owner, you are personally liable for all business debts and obligations.

General Partnership: 

Definition

Similar to sole proprietorship, but with multiple people. In this type of business, you are not required to have a written partnership agreement, but as a legal professional, I strongly recommend you take this step.

Characteristics

• Interestingly, a general partnership can be created unintentionally and create liability issues between owners. As partners, whether intentional or not, you're required to put your personal interest aside and to act in the best interests of the partnership at all times.
  
• A general partnership can be a legal entity apart from the individuals who own it. Yet the partners remain personally liable for all business debts.
  
• Partners generally file tax returns in the name of the business, but the business itself does not actually pay any taxes. Rather the individual owners assume liability or losses.
  
• Each partner receives a Schedule K-1 from the partnership.  With new businesses, this can sometimes lead to "phantom income" if the partnership shows net income for tax purposes, but any available cash is used by the business and not actually distributed to the partners.

C-Corp: 

Definition

This is the traditional corporation established by filing Articles of Incorporation with the secretary of state.  It is a separate legal entity and provides "limited liability" for the shareholders or investors. 

Characteristics

• Creditors can only go after assets of the corporation and not the shareholder's individual assets.  Therefore, the shareholders only risk losing whatever capital or assets they contribute to the corporation.
   
• The major downside is potential double taxation: the corporation pays income tax. Then it pays shareholders and they are taxed on the same income.

S-Corp: 

Definition

Same basic structure as a C-corp, but the shareholders can file an election with the IRS to be taxed as a partnership, thus avoiding the double income taxation. 

Characteristics

• Because S-Corps protect business owners from personal liability and provide pass-through taxation, it is one of the most common small business entities. 
  
• The number of shareholders  are limited.
  
• An S-Corp can have a single shareholder.
  
• Along with LLCs, this is the most common small business entity.  

Limited Liability Company (LLC):

Definition

An LLC is very similar to an S-Corp, but simpler to establish and more flexible to operate.   It offers limited liability protection and pass-through taxation. It can be managed by a board of directors or more directly by the owners, which is often the case with small, startup businesses.

Characteristics

• Since LLC's and S-corp's are so similar, choosing between the two often comes down to specific tax issues that apply based on the type of business.
  
• One difference is the way income is taxed. Generally, distributions from LLC income are subject to self-employment tax, whereas only the portion of distributions from a S-corp deemed to be "salary or wages" are subject to employment taxes.
  
• LLCs use different terminology than corporations:
• shareholders = members
• directors = governors
• officers = managers
• Along with S-Corps, this is the most common small business entity

So which type is right for your small business? That question is best answered by your attorney and your tax accountant. Although money is tight at start up, the investment in sound advice will save you headaches down the road.