Small Business Series: Choosing The Legal Structure For Your Business

Incorporating your business is far from a formality. Your legal structure can determine your liability risks, taxes, and what rules and regulations your business is subject to.

Most business fall into one of these five types:

• Proprietorship
• Partnership
• Corporation
• Limited Liability Company or “LLC”
• Non-Profit or Cooperative

Each of these have organizational differences, which is why it’s important to carefully consider which one best fits your business. While this article may serve as a helpful guide, it’s best to speak with tax and legal professionals to fully understand the ins-and-outs of business structure, and whether or not you should incorporate.

Proprietorship:

A proprietorship assigns complete control of operations  to a single owner. Since businesses are, by default, classified as a proprietorship, it is the most common. For this reason, proprietorships are very easy to form. Even better, by owning the entire business and assuming its liabilities, you are entitled to virtually 100% of the company’s profits. Profits and losses must be reported with a 1040 tax return.

The downside, however, is that there is no distinction between a proprietorship and the personal assets of the business owner. In other words, you could be held personally liable for any legal issues or damages that arise from your business. Your personal assets, such as your car, savings, and non-homesteaded property, could be garnished to pay back outstanding debt and back taxes. Because of the small and risky nature of some proprietorships, banks and investors might be wary about putting money into the business. This means that you might struggle to secure financing, which could put the entire future of your business at risk.

Partnership:

A partnership is similar to a proprietorship, but instead of having one owner, a partnership has at least two. Partnerships are effective ways to create businesses because they keep costs lower and help protect owners from being held legally responsible for the actions of their partners.

When working with partners, it’s important to draft a partnership agreement. This can be formal or informal, but ideally is a written, agreed upon contract between the involved parties that should establish things such as control of operations, splitting of costs and profits, and legal responsibility. If this agreement isn’t in place, there may be no recourse in the event of a partner acting outside of agreed upon terms.

Corporation:

A corporation is what we usually think of when we think of “big business.” These business types can have multiple shareholders and investors, trade (i.e. “sell”) shares of the company either privately or publicly, and are not tied together with personal assets of people who own the business. Legally speaking, corporations are defined as their own entity or “person”, separate from the partners of the business.

While this business structure is typically used for larger companies, it is possible to have a small business that is considered a “corporation.” With over 30 million small businesses in the U.S. alone, there is a great deal of variety in what qualifies. The Small Business Association defines a small business as a company with less than 250 to 1,500 employees, depending on the industry, and as much as $38.5 million in annual receipts.

For “larger” small businesses, functioning as a corporation could be more useful than a proprietorship or partnership. For one, the business might be too large to be effectively managed by a single party, benefiting from having a board of directors or managing partners that oversee company operations. Corporations also have flexibility in terms of structuring their business in ways to best suit their financial needs. In addition, by creating and selling shares in your company, you will be able to raise capital without going into debt.

The downside to corporations comes in the form of taxes, since you might pay a higher tax rate compared to other business types. Even if your corporation is exclusively chartered in the state of Florida, a generally tax-friendly state for businesses, you could be double taxed on money you earn. This taxation takes place once on the corporation’s earnings as a whole, and again as personal income earned through a mix of your shares and salary. There are two types of corporations, an S corporation and a C corporation.

LLC:

A Limited Liability Company, better known simply as an “LLC”, combines the above business types to create a hybrid. As its name would suggest, an LLC is designed to limit the legal responsibility of a business owner by protecting their personal assets from the threat of lawsuits.  If an LLC has a sole owner, it is taxed the same as a proprietorship. This is also the case with multi-owner LLCs, except you only pay taxes on the income allocated to you per your partnership agreement.

Non-Profit / Cooperatives:

Non-profit, not-for-profit, and cooperatives are organizations designed with the intention of providing a public good or charity and are often referred to as “non-business entities.”  The government provides a number of benefits to these organizations to help them achieve their goals, such as tax exemptions, government grants, and the ability to receive donations. Because of their tax-free status, they are held to strict standards to prevent any intentional or unintentional financial misuse. Non-profits are regularly audited to ensure compliance.
 

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It’s important to consider what best fits your own personal business, depending on how much income your business has, your other partners and investors, and your company’s goals. Incorporating correctly can save you money in taxes and protect you from being legally responsible for your business by keeping your personal assets safe.

This article is Part 2 of our series on Small Businesses. Read part one on the steps you need to follow to start your own small business!

To help your business reach its full potential, you need a partner in your financial growth. View Florida Credit Union’s business product offerings and see how we can help your business reach new heights.