Before you start your business, you need to give careful thought to the type of legal structure that you will choose. The decision that you make will likely have dramatic implications for years to come, especially regarding personal liability exposure, taxation, your potential to attract investors, and your ability to main control of your company.
At the risk of oversimplifying, in the US there are five basic choices when selecting a legal structure for your business.
Defining Legal Structures for Businesses
A limited liability company (LLC) is a way to organize a business that limits the liability for the owners, who are called the members. It’s flexible and scalable, as you are taxed more like an individual person than a corporation, but it can shield you from the personal liability associated with a sole proprietorship.
A corporation is a company or group of people authorized to act as a single entity. The liability is put on the corporation itself, and it is taxed separately from the owners and shareholders. A corporation is a more formal structure than a limited liability company, as the owners of a corporation are called shareholders and are formally issued shares of stock in the corporation.
Corporations that are “C” corporations are fully taxable entities themselves. This means that not only does a “C” Corporation have to pay taxes on its profits, but assuming the C corporation distributes profits to shareholders (called dividends), they shareholders must each individually pay taxes on this income as well.
Corporations may also elect to be “S”corporations. Unlike C corporations, S corporations are not subject to dual taxation. Instead, the profits of a S Corporation are declared as personal income on each shareholder’s federal income tax statement. Note that individual state governments may or may not recognize the S corporation status and may or may tax S corporations directly. Also, S corporations face more restrictions than C corporations regarding the number of shareholders and what kinds of organizations beyond individuals may be shareholders. Hence, start-ups that plan on raising money from venture capital firms for example, should not elect “S” status.
A sole proprietorship is a type of business entity that’s run and owned by a single person. For this option, there is no legal distinction between the business and the owner.
Lastly, a partnership is a joining of individuals in which the partners share profits or losses; risks and rewards are generally shared proportionately to ownership. However, if the partnership runs debts that the partnership can’t pay for and that one partner either can’t or won’t share in paying, then the remaining partner or partners may be held personally liable for 100% of the debt of the partnership.
Choosing the Right Legal Structure for Your Business
Not only is every business situation unique with regard to the best type of legal structure, but also your personal situation, such as your degree of risk aversion and your net worth outside of the business, is an important variable to consider.
Because there are a number of disparate variables to consider and weigh when choosing a corporate structure, I will give examples of different scenarios and which corporate structure I would apply to each situation.
I would also recommend that, in addition to getting comfortable yourself with the basic pros and cons of the four main business structures, you also consider consulting a business attorney before you form your business organization.
In the following business situation, I would choose to choose to establish a Sole Proprietorship.
Sample business: Lawn Mowing Service
• No employees
• All services performed by the owner
• No outside investors expected
• Revenue expectation year one = $50,000
• Owner net worth outside of business = $35,000
• Total initial business investment expected = $20,000
It’s quite possible in this kind of business that the operator might face some small claims for damage to property. However, the chance of facing and losing a claim for a much larger incident is small. Hence, it is my opinion that the added legal protection of a separate legal entity, such as an LLC or a corporation, is likely not worth the cost and paperwork involved.
However, if employees were hired to work in the service, the possibility of significant risk increases slightly with the addition of each staff member. So the more employees that were hired the more likely I would consider another form of legal organization, most likely an LLC.
There might be some tail risk, for example, if an employee becomes injured and disabled on the job and the workers’ compensation insurance that you are legally required to carry does not adequately cover all claims. Also an employee may be more likely than the owner-operator to cause damage to a customer’s property or become involved in an automotive accident with company equipment.
For the following business situation, I would choose to choose to establish a Partnership.
Sample business: Online Marketing Consulting Firm
• Two partners, one part-time administrative employee
• All professional services performed by the two partners/owners
• Outside investment was a $20,000 startup loan from a relative
• Revenue expectation year one = $150,000
• Owners respective net worth outside of business = $105,000 and $30,000
• Total initial business investment expected = $35,000
In this situation, I believe that the downside risk is probably minimal. Yes, in these kind of businesses you often have clients who complain about the quality of the work, and some even threaten to sue. But, as long as you’re doing quality work, fulfilling your contractual obligations, and keeping solid documentation, your chances of actually losing a significant claim in court are minimal. I would tend to skip the cost of forming an entity that would limit legal risk, such as an LLC or S Corp.
However, no matter how friendly you are with your partner, I would have a very clear and binding partnership agreement, including how you are going to dissolve the partnership if you come to a major disagreement.
LLC, Limited Liability Company
The following business situation I would choose to choose to establish as a LLC (a Limited Liability Company).
Sample business: Dog Kennel Service
• One owner and six employees
• No outside investment; owner is financing business with personal savings
• Revenue expectation year one = $150,000
• Owners net worth outside of business = $45,000
• Total business investment expected = $70,000
Given the above details, even an owner who is particularly risk-adverse and well-insured would be wise to choose a form of business organization that protects their personal assets in case the business goes south. In this situation, the number of employees, the fact that you’re going to have a physical premise that customers will visit, the value of the dogs, and the danger associated with the animals would suggest that there is significant risk associated with the business. Hence, for this business I would choose an LLC, Limited Liability Company, structure.
In this situation, an S corporation would not be a bad choice either, but I would tend to choose an LLC.
The following business situation I would choose to choose to establish as a C Corporation.
Sample business: Internet Food Delivery
• One founder/owner and six employees
• Initial outside financing of $50,000 from family and friends, but expect another round of financing of over $500,000 from venture capital firms within 12 months
• Revenue expectation year one = $700,000
• Owners net worth outside of business = $15,000
• Total initial business investment expected = $70,000
The key in this situation is that the business expects to raise capital in the not-too-distant future from venture capital firms. These firms are going to invest only in a C corporation structure. In addition to that, even if the company wasn’t seeking VC investments, the nature of the business with the heavy delivery component, involving owned or non-owned company vehicles, significantly enhances the tail risk of the business.
In summary, while each business situation is different, and I would suggest you consult with a business attorney, if you’re still in doubt, I would consider choosing an LLC, Limited Liability Company.