Legal Structure and Your Business

Oh great. Another thing to think about. In this blog entry for our “So You Want to Start a Business” series, we tackle the different types of business entity. What form or type of business entity should you create? Most people do not know their options in this regard, let alone understand the potential risks or rewards resulting from that decision.

Understanding Legal Structure

Now first and (shamelessly) foremost, the best way to get good legal and financial advice is to track down the appropriate professionals. If you are confused, find someone in the know! Furthermore, take the time to understand your options and their respective implications. Hopefully this article can help lay out some of the options.

In this article, we will discuss the available business entity types and their various considerations. Now keep in mind that this article cannot solve all the issues of choosing a legal structure for your business. However, some general knowledge of the available legal structure options will help you in ultimately making the selection.

How can you choose the right Business Structure?

The Legal Structure Menu

Let’s start with a basic list of legal structures available to “non-professional,” “for-profit” business organizations in the United States (“professionals” such as doctors and lawyers must use special business entities with different liability and tax consequences not mentioned in this article):

  • Sole Proprietorship – owned by one person (or a married couple). If one or more owners enter the equation, the business automatically becomes a General Partnership unless some other type of entity is created.
  • General Partnership – owned by two or more persons. Generally speaking, a partnership, limited liability company or corporation can be a partner unless a Partnership Agreement or another applicable law or regulation states otherwise. (This is not always true, be sure to check your facts!) If you are considering joining an existing partnership, you will find our previous article Tips for Successfully Joining a Partnership helpful.
  • Limited Partnership – are the same same as a General Partnership, but differ in terms of formation, liability, operational, and taxation. Owners may be “General Partners” of “Limited Partners.”
  • Limited Liability Company (or LLC) – may be owned by one or more persons or other entities. Owners are called “Members.”
  • Corporation – may be owned by one or more persons or entities, called “stockholders” or “shareholders.” From a tax standpoint, may be a “Subchapter C” corporation or a “Subchapter S” corporation.

Legal Structure and the Legal System

Most of the aspects around legal structures including legal formation, legal effect and conduct come from state law. However, keep in mind that federal tax law and industry specific guidelines still apply. One of the more confusing aspects of state law and legal structure arises from the fact that state laws are not universal. In other words, state laws will vary. Especially if your business will be operating in multiple states, it pays to seek the help of a professional. For additional research materials, consider checking in with the IRS’ Business Structures guide and the Small Business Administration’s (SBA’s) outstanding Business Types starting page.

Your Small Business Legal Structure must consider state AND federal law!

Legal Structure Considerations

There will not be a ‘perfect’ legal structure for your small business. However, the best fit for your small business depends on many factors. We’ve made a list to help you get started:

  • For starters, what industry are you in? Some heavily regulated industries mandate that the business operate as certain types of entities. Examples are banks, liquor establishments or various types of franchise operations.
  • How do you plan to run the business? Do you intend for all owners to have a say or vote in business operations or do you want to limit or even prevent management participation by some owners? Will the business be managed by non-owners? The answers to these questions may impact your legal structure.
  • How complex is this legal structure to form? How complex is this legal structure to maintain and keep compliant with laws and regulations? For example: a sole proprietorship or even a general partnership may be formed without any formal documents (although this may not be advisable – read our previous article entitled, Not Incorporating is Risky Business). Accounting, reporting and the preparation and tax preparation may be significantly simpler or more complex depending on the form of business used.
  • How easy is it to transfer ownership?
  • How many owners does this legal structure allow? How involved will said owners be? It goes without saying you should figure out the number of owners in your small business beforehand. Certain entity types are available only to single or multiple owners. Also, in some cases certain owners may wish to be “passive” investors and have limited authority, responsibility and liability.
  • What type of owner exists in this legal structure? Some only allow owners to be individuals while others allow other business entities to be owners.
  • How does this legal structure handle liability to customers, vendors and other third parties? Some legal structures place liability on the business, while others place it on the owner, allowing their assets to be targeted.
  • How does this particular legal structure handle capital? Can it attract capital? How is capital distributed? The number of investors and the extent to which your business is capitalized by equity (ownership) investment versus debt (lending) will be an important consideration in your choice of legal structure. If seeking investors, remember that third-party investors may demand certain legal or tax treatment before they are willing to invest.
  • How are taxes handled? This is perhaps the most crucial and complex area when it comes to choosing a legal structure. Each type of legal structure presents a different tax implication. These differences may occur at both the federal and state level. We discuss some this in more detail in our previous article, Not Incorporating is Risky Business.

This is just a partial list of the various factors that need to be carefully analyzed. The details behind these differences are complex and a complete understanding requires time. Feel free to contact us with any questions.

Law 4 Small Business (L4SB). A little law now can save a lot later.

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