It is as the old saying goes, “You can’t build a strong standing house without a solid foundation.” The same goes for your business. You must take great care in choosing your business structure. The structure you choose will have legal and tax implications that will set the foundation of your new business and inevitably determine whether your business will withstand the tests of time. The summary that follows should not supplement the work of an experienced business structure lawyer, but rather, as a start up in addressing your blossoming business’s needs.
There are four broad legal structures available to a new business. While this list is not all-inclusive, these structures are most relevant to start-ups and small businesses. They include sole proprietorship, partnerships, corporations, and limited liability companies (“LLCs”).
If your business is new and, in its infancy, you are what is considered a sole proprietorship. A sole proprietorship is not separate from its owner… Sole Proprietors are entitled to all profits and are responsible for all debts, losses, and liabilities of the business. You do not have to share your profits, but you will enjoy no limitation from liability.
A partnership is an inexpensive business structure in which two or more people share ownership of the business. A number of different partnership structures exist, which offer limited liability to different distinctions of its partners. A general partnership is the purest form of partnership. Here, two partners share in both the profits and losses of the business. Therefore, each partner is equally invested in the success of the business. Partnerships have the advantage of pooling resources to obtain capital. Partners will be liable for their own actions, as well as the business debts and decisions made by other partners. Further, your personal assets can be used to satisfy partnership’s debts.
A partnership agreement will establish the responsibilities, and profit and loss distribution of each partner, as well as other rules about the general or limited partnership. While partnership agreements are not legally required, they are strongly recommended. Consider consulting with a business structure lawyer when the partnership agreement is being drafted, as to not leave out any important details.
A Corporation is an independent legal entity owned by shareholders. It is created by filing documents with the Secretary of State. Generally, a corporation is taxed as a “C” corporation (“C-Corp”). However, an S corporation (sometimes referred to as an “S Corp”) is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.
The Corporation itself is held legally liable for the actions and debts the business incurs. Corporations are more complex than other business structures because they have to follow more structured statutory requirements (Board of directors, meetings, etc.) that are different for each state. Generally, the end game is to, “Go Public”, through an initial public offering (“IPO”).
An LLC is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. An LLC is formed by filing proper documentation with the Secretary of State. When an LLC is properly formed, it will combine the “pass-through” federal tax treatment of partnerships with the liability protections of a corporation. Often, businesses that would otherwise qualify as an S corp., general or limited partnership, may derive a significant benefit from organizing as an LLC, because it may retain its limited liability protection while collaborating with favorable partnership tax treatments. Pass-through taxation allows LLC members to report profits and losses on their personal federal tax returns which may result in paying less taxes.
Members are protected from personal liability for business decisions or actions of the LLC. This is similar to the liability protections afforded to shareholders of a corporation. It is important to remember that limited liability means “limited” liability – members are not necessarily shielded from wrongful acts, in particular costly mistakes made in running the business. Consequently, it is up to the members themselves to decide who has earned what percentage of the profits or losses. Therefore, an Operating Agreement will protect the business in all facets and prevent partnership disputes that may lead to legal complications.
Forming your business entity is an important legal step in developing your business. Do not let the stress and time constraints keep you from forming your entity today. If you have any questions regarding business formation or steps to take with your newly formed business, reach out to a business structure lawyer today. Please contact Attorney Harrison at 614.440.1395.
By Attorney Chad Hirschauer