How to Choose a Business Structure

When clients come to my law clinic to start a business, the first question they usually ask is: “Should I be a partnership or a corporation?” Making your business “legal” is such an exciting step…most people just can’t wait to do it!

But there are a few questions you need to ask yourself before you decide on a legal form or structure. You should think about these questions even if right now your business consists of only you working in a closet out of your home. If you’re thinking about building a business, eventually there will have to be other people involved, and potentially other people’s money as well.

Management & Control

Do you envision a business where you are totally in charge of all strategic decision-making? Or are there one or two key people you plan to share decision-making power with? How formal do you want the decision-making process to be? Do you envision a board room of powerful players where key strategic decisions are made by majority vote? Try to think ahead to the future here as well. As your business grows, there may be too many strategic decisions for one person to make. What kind of management team would you be comfortable working with?

Roles of Other Players

If you have decided not to do everything on your own, how do you envision sharing responsibilities? Co-equal relationships with strategic partners? Employees? Outsourcing to independent contractors? Joint ventures with other independent companies?

Capitalization Costs

Where do you plan to get the funding for your company? Are you primarily using your own assets? Do you plan to apply for bank loans or venture capital? Do you have friends and family members who are willing to invest in your company? If so, would it be structured as a loan (to be paid back with interest) or an equity investment (where they get a share of the profits)?

Allocation of Profits and Losses

How do you plan to allocate profits and losses? Do you see yourself paying wages or salaries to your employees? Or do you envision sharing a portion of the profits with some or all of your co-workers? When all expenses have been paid, will all the profits go to you, or are there others (such as investors) who will have a stake in your profitability?

Liability

How risky is the business you are starting, and how willing are you to take on that risk?    For example, if you are selling food products, there is the risk that people might get ill from contaminated ingredients.  If you are an athletic coach, there is the risk that people might get injured participating in your trainings.  If you have a brick-and-mortar store or office, there is the risk that people might get injured on your premises.  And in any kind of business, there is the risk that your company might not be able to deliver on its contractual promises.

In any of these situations, the injured party may sue your company.  But there is also the possibility that they will sue you personally.  So you need to weight the risks against your own personal financial situation.  Do you have a lot of personal assets that you would like to insulate to the extent possible from the risks of your business?

Taxes

This is a question you should discuss with your accountant before making a decision about a legal structure. In general, there are two ways your business entity can be set up for tax purposes. The business itself can pay taxes on net income; then individuals within the business will only pay taxes on whatever income is allocated to them individually. This is often called “double taxation,” because taxes are paid by both the business and individuals within the business. But it can be advantageous for some businesses, depending upon your own personal financial circumstances.

Another option is to have the business set up with “flow-through” taxation, so that there is no taxation of the entity itself. All income and expenses are passed along to you and other key players, according to the allocation of profits and losses you set up when structuring your business.

WHEW!  Those are a lot of questions to think about.  Now I’m going to let you just sit back and relax for a few while I give you a brief summary of the most common business types.

First, I need to make a disclaimer.  The laws governing businesses vary from state to state, so you need to consult a lawyer in your own state about setting up your business.  This post is not intended as legal advice, and you should not rely on it to make any legal decisions.  That being said, what I am going to tell you will give you a general overview of the differences between business entities.  That way, you can go to your lawyer with a good list of questions to ask and information to provide.

Although there are other variations, I am going to tell you about four basic business entities that suit the vast majority of businesses:  sole proprietorships, limited liability companies (LLC’s), partnerships, and corporations.

Sole Propietorships

This is the simplest form of business to set up.  You will not need to file any formation documents with the state where you are doing business.  But you may need to file other forms, such as tax forms and business licenses.  Generally, though, the cost and time involved in starting a sole proprietorship are minimal.  You choose a name for your business, open a business checking account, and you are in business.

You might want to consider a sole proprietorship if (1) you plan to make all of the management decisions for your business, (2) you don’t envision hiring a lot of employees or independent contractors, (3) you are providing the start-up costs from your own savings, (4) you plan to take all of the profits and losses from the business yourself, (5) don’t have any concerns about liability, and (6) you will benefit from flow-through taxation (taking the business income and losses on your own personal income taxes).

The major disadvantage to the sole propietorship is that you have no protection from personal liability.  But it can work well for home-based businesses with little risk.  For example, lots of artists and crafts people operate this way.

Partnerships

When two people are thinking of starting a business together, they often refer to themselves as “partners.”  And a partnership is one way of structuring a business with two or more people who see themselves as co-equals.  Law partnerships are one common example of a business model where the partners share decision-making authority, and allocate income and expenses among themselves based on their contractual agreement.

A partnership is created by a partnership agreement, which is a contract that describes how the partners choose to allocate rights and responsibilities, income and expenses, management decisions, and the like.  In the absence of a contract, most states have laws that allocate income and expenses equally among the parties.

One common concern about partnerships is that each partner is responsible for the acts of all other partners.  And partnerships do not provide any insulation from personal liability.  Partnerships also use the flow-through taxation model, so each partner is taxed on his or her share of income and expenses.

Corporations

This is the kind of business most people think of when they are talking about large businesses such as General Motors, Apple, and the like.  But there are some corporate forms, such as Subchapter S corporations and closed corporations, that may be appropriate for smaller businesses.

Corporations are the most formal kind of business structure, and are heavily regulated by the states and, to some extent, the federal government.  To start a corporation, you need to file Articles of Incorporation with the state.  You also need to create By-Laws that govern how the corporation will function.

One of the key characteristics of corporations is that they raise their capital funds by issuing stocks.  For large corporations, the stocks are usually publicly traded and are heavily regulated by the Securities and Exchange Commission.  But smaller corporations that are raising funds from a small, intimate group of friends and family members may be exempt from those laws.  This is a very technical area and one that would require personalize legal advice.

Corporations are governed by a Board of Directors, who make the strategic decisions for the company.  The Board hires managers to carry out the day-to-day decisions of the business.  In a small, closely held corporation, the board and the managers may be the same people.

One major advantage of the corporation is that it provides protection from personal liability for the actions of the company.  You should know, however, that no legal structure provides protection from you own negligent or intentional wrongdoing.

Corporations are generally subject to double taxation.  The corporation gets taxed on its net income, and shareholders are taxed on their share of the company’s earnings.  Employees are also taxed on their wages or salaries. The IRS does permit certain smaller corporations to choose Subchapter S status, which enables them to use the flow-through taxation model.

A corporation may be a good business model for your company if you need to raise capital from investors, and have sufficient resources to keep track of all the formalities.  In order to maintain your shield against personal liability, you have to keep accurate records of decisions made at board meetings, file regular reports with the state, and otherwise abide by all of the rules governing corporations in your state.

Limited Liability Companies

LLC’s are often called a “hybrid” model, because they provide some of the advantages of the corporation with the advantages of a partnership or sole proprietorship.  An LLC is formed by filing Articles of Organization with the State.  The manner in which the LLC will operate is governed by a contract known as the Operating Agreement.

In most states, an LLC can be started by just one person, or by a group of people.  The people who own the LLC are called “members.”

A one-member LLC is similar to a sole propietorship in the sense that one person has all of the management and control of the company, and also receives all of its profits and losses.

An LLC with two or more members is similar to a partnership.  The members allocate rights and responsibilites, profits and losses in their Operating Agreement.

The major difference is that the LLC provides members with protection from personal liability for the acts of the business.  (Remember, though, that you can’t be insulated from liability for your own negligence or intentional actions).

The IRS treats a one-member LLC like a sole proprietorship and the multi-member LLC as a partnership.  That means that they receive flow-through taxation.  However, the law permits the LLC to make an election to be treated as a corporation if that tax treatment would be more beneficial for the members.

Many people believe that the LLC provides the best of all worlds: flexibility in allocating decision-making and profits, limited liability for members, and a choice of how to be taxed.

But I want to end by repeating my disclaimer.  This summary glosses over a lot of details and technicalities that you should consider when choosing a business structure.  I hope it gives you a head start in thinking about the questions you want to raise when you consult with an attorney in your own state.