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How Business Legal Structures Work


Key Issues of Business Legal Structures

There are three key issues that differentiate the various types of business structures. By understanding these core issues first, you will be able to understand the advantages and disadvantages of each type of structure.

Taxes

How many times will I pay tax?

That's right - it's not a matter of if you will pay tax, but rather how many times will you pay tax. Certain structures are called pass-through entities, and the income and losses are literally passed through from the business to the individual for tax purposes. Other structures form a separate tax entity that is taxed by itself. Then, when earnings are distributed, the owner is taxed again on that business income.

Quite simply, you may not end up with the amount of money you think you will be getting. Look at the following example to see the difference in after-tax money that the owner receives.

The following numerical example shows how this issue can make a big difference in after-tax income to the owner, (which is what most business owners are mainly concerned about.) Assume the owner had a business that made $100,000 in the past year, and that the tax rates for business and individuals are 40%.

Using similar logic, it is important to note that many businesses will have losses in early years and that owners can obtain significant tax advantages by having these losses passed through to their personal income tax returns. The net effect will be less tax paid by the owner, thereby leaving him with more after-tax income.

Liability

Who is responsible for the debts and liabilities of the business? If you drive your car into another car, then you are liable for damages. Who is liable for the possible damages and debts incurred by your business? It depends on the type of structure. Some structures will limit your liability to your investment, whereas others will make you and your personal possessions liable for the damages and debts of the business.

You could lose everything you own in your business and in your personal possessions. This means your car, your house, your personal bank account and more. Your business can incur damages in any number of ways. For example, if you end up going bankrupt and still have outstanding bills, the creditors will come after your personal assets. Also, if a driver for your company accidentally kills a pedestrian, your business can become liable. Depending on the business structure, your personal possessions may also be at risk.

For example, Bob Smith's lawn care business has gone bankrupt. Unfortunately for Bob, his company owes a supplier over $10,000 for equipment that he had purchased several months ago on installment. The company no longer has the funds to pay off the debt, and is structured in a way that makes Bob personally liable for the debts of his business. The supplier takes actions against Bob's personal assets to recover the $10,000.

Administrative Costs

How much time and money will it cost to set up and run my business under this structure?

How much time, effort, and money will it cost you to set up and run the company? Some structures are very costly in this sense while others are relatively low maintenance.

While the first two issues (taxes and liability) are more important overall, administrative costs should not be overlooked. The costs of both money and time can be cumbersome, especially for a startup with fewer resources. These expenses include tax-filing requirements, complexity of startup documentation with appropriate agencies (i.e. articles of incorporation), and both federal and state laws dictating necessary behaviors of the business.

Bob Smith sets up his business as a structure that is extensive in its administrative costs. The set up alone costs Bob several thousand dollars and periodically Bob is required to hire an accountant to fill out paperwork and forms for several government agencies. All in all, these administrative procedures take up a good amount of Bob's time and money.