Choosing an appropriate legal structure is one of the first and foremost decisions you’ll make when starting a business. It will affect the way you pay taxes, how you handle bookkeeping, your personal liability and funding prospects. Each structure comes with its own benefits and drawbacks, which means there’s no one-size-fits-all solution.
In fact, your choice is best guided by sound counsel from a qualified business expert. You can obtain this advice from a number of different sources and it doesn’t necessarily have to cost a fortune. Many entrepreneurs choose to consult with the Small Business Administration or Service Corps of Retired Executives.
An attorney or accountant, while considerably more expensive in the early stages, is another solution that will serve as a valuable source of information and assistance throughout the life of your business. That said, it’s worth taking a moment to understand exactly how each type of legal structure will affect the way your business operates moving forward.
To start, let’s take a brief look at the four main types of business entities:
Sole Proprietorship: The simplest and most common form of organization, particularly among small businesses. A sole proprietorship is relatively easy to form and will afford you total managerial control. One disadvantage is that the owner is personally liable for the business’s finances, as well as potential issues such as lawsuits.
Partnership: This involves two or more people who agree to share the business’s profits and losses. Similar to a sole proprietorship, both partners are personally liable for the business’s financial obligations. On the other hand, you do benefit from not bearing the tax burden of profits.
Corporation: By forming a corporation, you effectively separate yourself from the business, as it becomes its own entity. The corporation itself is then taxed, as well as being held legally liable for its actions. A key benefit is that the corporation takes the liability away from the owner.
However, forming a corporation is more expensive and a greater amount of time will be put into record-keeping. Another potential drawback is double-taxation, but this can be avoided by forming an S corporation as opposed to a C corporation. This allows income and losses to be passed through on the owner’s tax returns.
Limited Liability Company: An LLC is a hybrid form of the partnership and corporation structures. It has become increasingly popular as it offers the best of both business forms. Owners of an LLC are protected from personal liability. You also benefit from being able to take in profits and losses without the business itself being taxed.
When choosing which type of structure to form, there are several criteria that you should evaluate. Consider the following areas when making your decision:
Legal Liability: Think about the extent to which you need to be insulated from legal liability. This will largely depend on the type of business you plan on starting and the potential losses associated with it. If your business lends itself to a high amount of potential liability, consider whether you can personally afford that risk.
If not, it may be better to consider other options. This is why many business owners choose to incorporate instead. As a result, any judgements or lawsuits made against your business won’t put you at risk of losing your personal assets.
Taxes: It’s worth looking into the opportunities you have to minimize taxation. Sole proprietorships and partnerships typically have less options available than corporations and LLCs. Remember that business losses can help you minimize personal tax liability, which is particularly helpful in the early stages.
Formation and Administration Costs: An important note on the above is that tax advantages may not be enough to offset the other expenses that come with alternative structures. This is particularly evident in the costs that come with forming a corporation, as well as record-keeping requirements, which can also take up valuable time.
Looking Forward: It’s easy to get “caught up in the moment” when first starting a business. Being so focused on getting off the ground can make you forget about the future implications of your decisions. For example, think about what will happen to your business if you decide to sell your share as part of a partnership.
You should also consider what might happen to your business when you’re no longer around to run it. A corporation can be brought down to your family members. The same may not be true for a sole proprietorship or partnership. The bottom line is that your current structure of choice may not suit your needs a few years down the line.
To help you make the right decision, let’s take a deeper look into each structure.
For entrepreneurs who intend to work alone, a sole proprietorship is usually still the best choice. Because your income and expenses are deducted from your personal tax return, you could be able to offset the taxation on income earned from other sources through the losses suffered in your business.
Of course, the other major advantage here is that you maintain complete control over business operations. It’s worth noting, though, that being personally liable for your business means that you’ll be placing your own assets at risk in the event of a business debt or legal claim. Raising money is also a potential challenge.
If you don’t intend on running your business alone, then a partnership will naturally be your next consideration. The advantage here is that partnerships don’t pay taxes on their income, but profits and losses are passed through to individual owners. Partnerships are more expensive to establish, though, namely due to legal and accounting services.
Being an independent legal entity, corporations are more complex than other structures. As a result, you’ll have to deal with a unique set of challenges and expenses that come with tax and regulatory compliance. On the other hand, there is the benefit that comes with liability protection. This ultimately comes down to weighing up the costs.
An LLC is the best structure for tax purposes. You also enjoy a greater level of liability protection, but without the increased costs of double taxation. You can further build on this if you start an LLC in Texas or another “tax haven” state. If you’re looking for an in-depth guide on the topic, be sure to check out these tips to start an LLC in said state.
The linked resource provides a wealth of information on everything you need to know about how to start an LLC in Texas. This includes valuable advice on choosing your business name, filing the necessary paperwork, forming your Texas LLC, creating an opening agreement and much more. There are also some vital points on handling your taxes.
As mentioned earlier, your best bet is to do some thorough research on each business structure before making your final decision. But even at this point, it would be wise to consult an experienced professional for further advice. Many business owners that chose the wrong structure regretted not asking someone for guidance when starting off.
Spending some time on choosing the right business structure is a worthwhile endeavor. By making the right decision, you can benefit from lower expenses and less complications moving forward. What’s more is that in the long run, your family may also benefit from your entrepreneurial successes when you’re no longer around.