Which Type of Legal Structure is Right for Your Business?

This is a guest post from Hal Shelton, SCORE small business mentor and author of The Secrets to Writing a Successful Business Plan. You can read his previous posts for Constant Contact here. 

You have a business idea, you’ve worked out the operations, and have the funding you need.

You’re ready to start a business, right? Not exactly.

You first need to form a company from which to run the business.

In this post, I’ll take a closer look at the various forms of legal structures to choose from, including: sole proprietorship, LLC, S corporation, and C corporation.

Types of Legal Company Structures

Here’s a summary of the key provisions and implications for the most used company structures. You should consult with a lawyer before making your decision.

Sole Proprietorship

This is the only organizational form that does not require an application to a state government. Therefore, it is the default organizational form. You wake up one morning, decide to be in business, and you are a sole proprietor. Of course, you may still need to register your business with the state and/or county, obtain a business license depending on the nature of the business, and prepare other paperwork.

As the term “sole” implies, this is an organization with one owner. So a husband and wife cannot be a sole proprietorship.This term relates to ownership and not the number of employees. A wife can be the sole owner and employ her husband and many other employees or vice versa.

As there is no personal liability protection in a sole proprietorship, a suit against your business can impact your personal affairs (in other words, a legal suit can end in a claim against your personal assets). While this may sound dire, for many small businesses, there may be few instances when this occurs.

When filing taxes for your sole proprietorship, use your personal IRS Schedule 1040 and attach Schedule C (“Profit or Loss from Business”), which, in effect, is a mini business income statement. Therefore, you should account for your business as a separate entity from your personal affairs.

On Schedule C, owner’s compensation is not an expense line item because it assumes that the difference between revenues and expenses, meaning net income, is the owner’s salary. It is on this amount that you will be assessed payroll taxes, via Form SE (“Self-Employment Taxes”), and on this amount, you can create a Simplified Employee Pension Individual Retirement Account (SEP-IRA) or a Solo 401K Plan and reduce your taxable income.

Limited Liability Company (LLC)

This organizational form has the personal liability protection benefits of a corporation without having all the required administrative and governance procedures. To obtain LLC status, you must apply to a state by submitting an application with an annual fee (each state is different, but it is generally in the $100 to $200 range).

With the state-approved LLC, there will be an operating agreement — think company bylaws. These will be the general rules for your company governance. In most cases, the state’s standard operating agreement is satisfactory, especially if you are a single-member LLC. However, if there are several founding members, you will want to review the operating agreement and make sure it fits your situation with an agreement and understanding among the co-owners. This is your operating agreement, so you can model it to your situation.

Entrepreneurs frequently select the LLC format to obtain personal assets liability protection. Many start-ups and most “idea” businesses have few assets, so a suit against the company will have no reward and the claimant will try to go after personal assets. But just because you have the LLC paperwork, this will not automatically provide the desired liability protection if you do not operate the LLC as a separate entity. So keep your business separate from your personal affairs — have a separate bank account, credit/debit card, letterhead business stationery, and so forth.

Where it becomes more difficult in keeping this separation is in obtaining funding. Often bank loans to start-ups require a personal guarantee and a lien on your personal assets. Some lawyers might argue this is sufficient to say that the LLC is not a separate entity and personal and business interests have been joined.

As an LLC owner, there are options on how to be taxed for federal and state income tax purposes. Most entrepreneurs select to have the LLC be considered as a tax pass-through entity and pay the taxes on their personal return(s), since, for most; the personal tax rate is lower than the corporate tax rate. So the LLC will file an information tax return to the IRS (no money is sent) and the owner(s) report and pay their agreed share on their personal tax returns.

Subchapter S Corporation

This form of organization has characteristics of both the LLC and C corp. There can be no more than 100 shareholders who are U.S. citizens or residents. Application is made to a state along with an annual filing fee. The subchapter S corporation will have a shareholders’ agreement. These are your bylaws, so design them to meet your needs.

You will have a board of directors and the corporate governance processes that apply. As this is a corporation, you can use “Inc.” in your company name, which to some is important, but to me is overrated. In some states, for example, California and Texas, if you are a subchapter S corporation or a C corporation, you must use “Inc.” in your name or otherwise disclose your corporation status so potential customers and vendors know claims against the company will be subject to corporate vs. sole proprietor asset safeguards.

Like with the LLC, in an S corp, there are elections to be made on taxation, and most entrepreneurs select to report and pay the federal and state income tax on their personal tax return.

C Corporation

C corporation is the legal form of organization adopted by most publicly traded companies. A C corp is a separate legal entity, a “person” under the law. Of all the organizational forms, this one has the most administrative and governance requirements, including a board of directors who have the ultimate fiduciary responsibility.

Since the C corp is a separate “person,” it pays corporate income tax. When distributions are made to the owners via dividends, these are taxed to the recipients. The term “double taxation” is used to describe this process.

Nonprofit

To become a nonprofit, first apply to a state to be a corporation under its Nonprofit Corporation Act, and then apply to the IRS on Form 1023 for 501(C) 3 or another of the nonprofit designations, and finally back to the state for its certification.

While 501 (C) 3 is the most common nonprofit form, under the IRC code in section 501, there are about 25 different nonprofit designations, depending on the type of activities/services provided.

Ready to choose the right legal structure for your business?

Selecting a business organization form does not have to be forever. You can start with a sole proprietorship or LLC, and at some future time change to an S or C corp.

Key Takeaways

• A sole proprietorship is the only form of organization where an application is not required; however it only applies to companies owned by one individual.
• To become a nonprofit is a three-step application process — state, IRS, and back to the state for certification.
• If you want to switch your structure in the future, you can revisit your decision and make the choice that makes sense down the road.

Have any questions we didn’t cover in this post? Ask your questions in the comment section. 

About the author: Hal Shelton’s business planning skills were developed as a certified SCORE small business mentor, corporate executive, nonprofit board member, early-stage company investor, and author of The Secrets to Writing a Successful Business Plan: A Pro Shares a Step-by Step Guide to Creating a Plan That Gets Results. Suggestions for additional topics are welcome; email Constant Contact or Hal directly from his website: www.secretsofbusinessplans.com.