How to choose the best legal entity for your business?

Updated: Sep 10, 2020

Choosing the best legal structure for your business requires knowledge of your line of work, and an understanding of local, state and federal laws. Tax laws are constantly changing and the need for capital is always present, so it's crucial for business owners to evaluate which business structure offers them the advantages that will save them money and help them grow. 


We've compiled the most common types of business entities and their notable features to help you decide on the best legal structure for your business. The most common types of business entities include sole proprietorships, partnerships, limited liability companies, corporations and cooperatives. Here's more about each type of legal structure.

 

Sole proprietorship


This is the simplest form of business entity. With a sole proprietorship, one person is responsible for all a company's profits and debts. If you want to be your own boss and run a business from home without a physical storefront, a sole proprietorship allows you to be in complete control.


Here are some of the advantages of this business structure: 

  • Easy setup. A sole proprietorship is the simplest legal structure to set up. If your business is owned by you and only you, this might be the best structure for your business. There is very little paperwork since you have no partners or executive boards to answer to.

  • Low cost. Costs vary depending on which state you live in, but, generally, the only fees associated with a proprietorship are license fees and business taxes.

  • Tax deduction. Since you and your business are a single entity, you may be eligible for certain business tax deductions, such as a health insurance deduction.

  • Easy exit. Forming the proprietorship is easy and so is exiting one. As a single owner, you can dissolve your business at any time with no formal paperwork required. For example, if you start up your own daycare center and wish to fold the business, you can simply refrain from operating the daycare and advertising your services. 


Partnership


This entity is owned by two or more individuals. There are two types: a general partnership, where all is shared equally; and a limited partnership, where only one partner has control of its operation while the other person (or persons) contributes to and receives part of the profits. Partnerships carry a dual status as a sole proprietorship or limited liability partnership (LLP), depending on the entity's funding and liability structure. 


Here are some of the advantages of this business structure: 

  • Easy to form. Like a sole proprietorship, there is little paperwork to file. If your state requires you to operate under a fictitious name ("doing business as" or DBA), you'll need to file a Certificate of Conducting Business as Partners and draft an Articles of Partnership agreement, both of which have additional fees. A business license is usually needed as well.

  • Growth potential. You're more likely to obtain a business loan when there's more than one owner. Bankers can consider two credit lines rather than one, which can be useful if you have a less-than-stellar credit score.

  • Special taxation. General partnerships must file federal tax Form 1065 and state returns, but, usually, they do not pay income tax. Both partners report their shared income or loss on their individual income tax return.


Limited liability company


A limited liability company (LLC) is a hybrid structure that allows owners, partners or shareholders to limit their personal liabilities while enjoying the tax and flexibility benefits of a partnership. Under an LLC, members are shielded from personal liability for the debts of the business if it cannot be proven that they acted in an illegal, unethical or irresponsible manner in carrying out the activities of the business. 


Corporation


The law regards a corporation as an entity separate from its owners. It has its own legal rights, independent of its owners – it can sue, be sued, own and sell property, and sell the rights of ownership in the form of stocks. Corporation filing fees vary by state and fee category.


Here are some of the advantages of this business structure: 

  • Limited liability. Stockholders are not personally liable for claims against your corporation; they are only liable for their personal investments.

  • Continuity. Corporations are not affected by death or the transferring of shares by its owners. Your business continues to operate indefinitely, which is preferred by investors, creditors and consumers.

  • Capital. It's much easier to raise large amounts of capital from multiple investors when your business is incorporated. 


Cooperative


A cooperative (co-op) is owned by the same people it serves. Its offerings benefit the company's members, also called user-owners, who vote on the organization's mission and direction and share profits.


Here are some of the advantages of this business structure: 

  • Lower taxes. Like an LLC, a cooperative doesn't tax its members on their income.

  • Increased funding. Cooperatives may be eligible for federal grants that help them get started.

  • Discounts and better service. Cooperatives can leverage their business size, thus obtaining discounts on products and services for their members.


For new businesses that could fall into two or more of these categories, it's not always easy to decide which structure to choose. You need to consider your startup's financial needs, risk and ability to grow. It can be difficult to switch your legal structure after you've registered your business, so give it careful analysis in the early stages of forming your business.


Here are some important factors to consider as you choose the legal structure for your business. You should also plan to consult with your CPA for his or her advice.


Flexibility

Where is your company headed, and which type of legal structure allows for the growth you envision? Turn to your business plan to review your goals, and see which structure best aligns with those objectives. Your entity should support the possibility for growth and change, not hold it back from its potential. 


Complexity

When it comes to startup and operational complexity, nothing is more simple than a sole proprietorship. You simply register your name, start doing business, report the profits, and pay taxes on it as personal income. However, it can be difficult to procure outside funding. Partnerships, on the other hand, require a signed agreement to define the roles and percentages of profits. Corporations and LLCs have various reporting requirements with state governments and the federal government. 


Liability

A corporation carries the least amount of personal liability since the law holds that it is its own entity. This means that creditors and customers can sue the corporation, but they cannot gain access to any personal assets of the officers or shareholders. An LLC offers the same protection, but with the tax benefits of a sole proprietorship. Partnerships share the liability between the partners as defined by their partnership agreement. 


Taxes

An owner of an LLC pays taxes just as a sole proprietor does: All profit is considered personal income and taxed accordingly at the end of the year. 


Control

If you want sole or primary control of the business and its activities, a sole proprietorship or an LLC might be the best choice for you. You can negotiate such control in a partnership agreement as well. 


Capital investment

If you need to obtain outside funding, such as from an investor, venture capitalist, or bank, you may be better off establishing a corporation. Corporations have an easier time obtaining outside funding than sole proprietorships. Corporations can sell shares of stock and secure additional funding for growth, while sole proprietors can only obtain funds through their personal accounts, using their personal credit or taking on partners. An LLC can face similar struggles, although, as its own entity, it is not always necessary for the owner to use their personal credit or assets. 


Licenses, permits and regulations

In addition to legally registering your business entity, you may need specific licenses and permits to operate. Depending on the type of business and its activities, it may need to be licensed at the local, state and federal levels. 


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