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How Business Legal Structures Work


Types of Business Legal Structures

Now let's talk about the basic advantages and disadvantages of each type of structure.

Sole Proprietorship

Simple Definition

A legal form of business that makes no legal distinction between the individual owner and the business itself.

Advantages

  1. Administrative setup and maintenance costs are low
  2. Relatively few regulatory requirements
  3. Owner is only taxed once on his or her personal income tax return

Disadvantages

  1. Owner is personally liable for the actions of the company
  2. Can be difficult to raise capital for the business

Other comments

  • Typically the sole proprietorship is set up as the owner's name (e.g. Bob Smith). The owner can choose to operate his or her business under a different name (e.g. Smith's Lawn Care) but then must file a doing business as form with the appropriate government body.
  • It is possible to self-insure yourself against the personal liability assumed by this structure.

General Partnership

Simple Definition

Similar to a sole proprietorship but with multiple owners (a sole proprietorship cannot have more than one owner). Like a sole proprietorship, a partnership is not a separate legal entity from its owners.

Advantages

  1. Administrative setup and maintenance costs are low
  2. Relatively few regulatory requirements
  3. Owner is only taxed once on his or her personal income tax return

Disadvantages

  1. Owner is personally liable for the actions of the company
  2. Each partner is responsible for the business dealings of other partners. This is very important to understand. If Partner A enters into a very bad deal under the name of the partnership, then all other Partners are responsible for making good under that contract. Consequently, selecting your partners is of crucial importance.

Other comments

The partnership agreement is the rule book of the partners. This can be drafted with the help of a qualified lawyer to help the partnership deal with such issues as:

  • Initial investment of partners
  • Distribution of profits and losses
  • Each partner's responsibilities
  • New partner entrance into partnership
  • Old partner exit from partnership

Limited Liability Partnership

Simple Definition

Similar to a general partnership but with a separate classification of partners (see Other Comments section below for further explanation).

Advantages

  1. Owner is only taxed once on his or her personal return
  2. Liability can be limited (for limited partners see other comments below)

Disadvantages

  1. More complex filing and administrative requirements than a general partnership
  2. General partners still have personal liability - makes sense if there are numerous passive investors who wish to limit their liability.

Other comments

As opposed to a general partnership, a limited liability partnership has two kinds of partners, general and limited. General partners are similar to those in general partnerships they operate the business and assume liability. Limited partners, on the other hand, are merely investors and, therefore, have no control or operational power. They do have limited liability.

C-Corporation

Simple Definition

A legal form of doing business that creates a separate legal entity from the individual owners. This legal entity can act and do business on its own just as a person would do (i.e. borrow money, enter into lawsuits and contracts, etc.).

Advantages

  1. Shareholders are not personally liable
  2. Ownership is easily exchanged between individuals
  3. Company does not cease to exist with the death of owners
  4. Easy structure for which to raise capital

Disadvantages

  1. Owners are taxed twice
  2. High administrative costs to setup and run
  3. More regulatory requirements than other structures

Other comments

It is important to remember that a C-corporation is considered a separate legal entity from its owners. This is the source of its relative advantages and disadvantages, especially regarding taxes and liability.

S-Corporation

Simple Definition

A type of corporate legal form that is taxed like a sole proprietorship. Its formation is subject to certain legal criteria such as a maximum number of shareholders.

Advantages

Owners are only taxed one time. Shareholders are not personally liable

Disadvantages

Higher administrative costs to setup and run than partnerships and sole proprietorships. More regulations than partnerships and sole proprietorships. Certain limitations on who can be an owner (U.S. citizens, etc.)

Other comments

S-corporations are limited to a certain number of shareholders (75), whereas a C-corporation can have unlimited shareholders.

Limited Liability Company (LLC)

Simple Definition

A hybrid legal form of business that is taxed like a sole proprietorship with the same liability protection of the corporate structure.

Advantages

Owners are only taxed one time. Shareholders are not personally liable

Disadvantages

  1. Higher administrative costs to setup and run than partnerships and sole proprietorships
  2. More regulations than partnerships and sole proprietorships
  3. Limited life of entity (usually limited to 30 years)
  4. LLC laws are not uniform and therefore doing business in multiple states as an LLC can be complex

Other comments

The L.L.C. is an extremely popular structure. Since there are many similarities between LLCs and S-corporations, the list below shows some of the differences:

LLC relative advantages over S-corporations:

  1. No restrictions on the number of owners (S-corps limited to 75 owners)
  2. Can have non-U.S. citizens as members (S-corps cannot)
  3. More flexibility in distributing income (S-corps percentage of ownership determines the amount of pass-through income)

LLC relative disadvantages over S-corporations:

  1. Need at least two people to form an LLC (S-corps only need one person)
  2. Limited life (S-corps are perpetual)
  3. LLC members need other members' approval to sell their interest (S-corps owners need no such approval)
  4. LLC may have to pay more self-employment taxes than S-corps due to IRS regulations forcing active LLC members to pay self-employment taxes on both salary and distributions from the company, as opposed to S-corps members who do not have to pay taxes on distributions.

The key factors that differentiate structures are summarized in the chart below:


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