Understanding the Legal Structure of Business

This is a guest blog entry by James Kim.
Starting up a company is no easy feat. Branding, employees, finances, and advertising are just some of the things you may be juggling in the beginning phases of your business. But the process becomes even more complicated when you have to decide on a business structure or file taxes. Not to worry! Here we’ve compiled a list of each business structure and their pros and cons, providing a business solution for just one of your conundrums.
Sole Proprietorship
A sole proprietorship occurs when one person owns a business on their own. In this structure, a person and a business act as the same legal entity: the businesses liabilities, debts, and legalities are the sole proprietor’s liabilities, debts and legalities. Therefore, the business profit “passes through” to the business owner and these profits are recorded in an individual tax return.
Pros:
-Easy tax recording
-Simple to establish and maintain
-Low startup fees
-No “double tax,” or taxation on corporate income as well as individual income
-Complete control over your business
Cons:
-High personal liability
-Limited access to capital (cannot sell shares in exchange for capital)
Partnership
A partnership is a business model with two or more people carrying on a business together. Like sole proprietorships, partnerships pass their profits to the partners and are taxed for these profits in the individual income tax return.
Pros:
-An array of skills contribute to the business decisions
-Easy to start
-Inexpensive to start
Cons:
-Possibility of disagreement
-High personal liability
-Shared profits
-Give up full control over business
C Corporation
In any corporation (c or s corp), shareholders trade money and/or property for the capital stock. The distinguishing factor of a c corporation is its taxing processes. Instead of passing the profits through to the shareholders, c corps are taxed on both individual and corporate incomes in a process called “double taxation.”
Pros:
-Easier to get funding from angels or venture capitalists: c corps have the most flexibility when issuing shares because they can have an extremely high number of shareholders with which to give to VCs or angels in exchange for capital
-Employee incentive plans
-Limited personal liability
Cons:
-Complex tax recording/filing
-Double taxation
S Corporation
An S corporation provides entrepreneurs with the limited liability of a corporation plus the “pass through” taxation process of sole proprietors and partners. An s corp can have no more than 100 shareholders, unlike the unlimited shareholders of c corps.
Pros:
-No “double tax”
-Limited personal liability
Cons:
-There can be no more than one class of stock
-Limited shareholders
Limited Liability Company
If your business will most likely engage in some sort of riskier activity (the use of hazardous materials, selling of edible goods, caring for children or animals, requiring injury-prone actions), you should opt for the LLC, which protects your personal assets from business debts and claims. There are no tax advantages (or disadvantages) to forming an LLC: LLCs with one owner file for taxes as a sole-proprietor, while LLCs with multiple owners file taxes as partnerships.
This is because the federal government does not identify LLC as a classification, so a member (and owner of an LLC) must file as a corporation, partnership, or sole proprietorship tax return. A Form 8832 is filed to establish a business classification. Owners of an LLC may also have to pay additional state taxes, or “franchise taxes,” in addition to the income tax.
Pros:
-Flexibility of management/taxing structure
-Limited personal liability
Cons:
-“Franchise taxes,” a tax solely required of LLCs
-Possibility of disagreement
-More difficult to raise capital
Choosing a legal structure is one of the most important decisions an entrepreneur has to make in the beginning stages of his/her company. Hopefully this list gave you a better sense of which one is right for you.

James Kim is a writer for Choosewhat.com. ChooseWhat is a company that provides product reviews and test data for business services and products. Their goal is to help small companies make informed buying decisions on business solutions that help their business.

2 comments on “Understanding the Legal Structure of Business

  1. this website is unhelpful…. i am a student and this has not helped me one bit to understand what a legal structure…

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