Starting a business can be a great venture for someone with an idea to sell or the drive to make it work. However, there are many parts that make a company and in order to get yourself off the ground and running, you need to have an understanding of them. One of these is the legal structures that every business must follow. There are a number of ways that a business can register itself as a legal entity and they all offer different ways of operating, perks and taxation methods. To help you get started, here are some of those legal structures and what they mean to you.
What is a legal structure?
Sometimes referred to as a business ownership structure, the legal structure refers to the key components of your company including the tax rules and financial liability. As referenced above, we are going to go through four of the structures available to you and discuss their pros and cons. Regardless of the choice you make, you should ensure that your company is set up using the correct legal proceedings and follows the appropriate tax laws.
We are going to start by looking at the two types of corporation available to you. A corporation is a completely separate legal entity to its owner which means the person(s) who owns the company is protected from the company’s liability and debts. A corporation can also raise funds through selling stocks in the company, which in turn means that the ownership can be transferred or split via the shares. What this means is that a corporation comes with a specific legal structure that must be adhered to, and is as follows:
- Directors appointed by shareholders
- Officers employed by the directors
- Officers who run the day-to-day operation
You can choose to be the 100% owner of all the shares in your company and therefore elect all of the roles listed above. In fact, you can appoint yourself to these roles.
The benefits of a corporation include significant tax benefits, the widest range of deductions and expenses allowed by the IRS as well as that a corporation is the most recognized business entity worldwide. However, there are cons to a c-corporation and one of those is double taxation which means personal income tax and corporate tax are both paid. There is also more paperwork involved when compared to an LLC which we will come onto shortly. S-Corporation
The second type of corporation is known as an s-corporation. This type of corporation can be formed by the shareholders following the holding of a vote to change the company’s status. One of the reasons they might consider doing this is the alternate tax setup of an s-corp.
Businesses that operate under the s-corporation legal structure are able to avoid the double taxation that c-corps have to pay. This is because the shareholders of an s-corp can have the income and losses divided between themselves and written off in their personal tax claims. This different way of taxation is preferable to smaller companies and may not benefit a business that has grown beyond operating at a loss.
Companies can choose to switch back to a c-corporation if they so wish.
Limited Liability Company (LLC)
An LLC is a combination of the four structures that are being outlined here in some ways. Similar to a corporation, an LLC is a separate legal entity to the owner and therefore comes with benefits with regards to liability issues. However, different to a corporation and comparable to the next section of sole proprietorship, the owner of an LLC can have profits and losses added to their own personal tax return.
An LLC also separates itself from a corporation in so far as it doesn’t allow the business or owner to raise funds through stock options. Unlike the structure discussed under corporation, an LLC has its own way of operating that businesses must adhere to. This is called an operating agreement and means that all functional and financial decision must follow the rules it has set out. The reason for this document is that it outlines that ways the business shall be run in a way that will meet the specific needs of the owner.
If you choose to set up business under this structure, from the decision to create a business address for LLC to some of the finer details, it is likely to come down to the to option of having the protection of corporate liability without the formalities of setting up a corporation. A con of an LLC includes the fact that it is more expensive than a DBA and operates within a more formal and document heavy world. Sole Proprietorship or DBA
The final type of business structure that we are going to look at is a sole proprietorship, also known as a Do Business As (DBA). This structure has been referred to above due to its differences in liability and taxation to the other three. A DBA is the legal name given to a business that is operating under a different name from its owner, but is not separate to the owner. What that means is that the owner of a DBA is entirely liable for all financial consequences of business, including debt, as well as the legal obligations.
One of the positives of operating under a DBA is that it is considered to be a much easier style of business than the other models. The reason for this is that you are totally in control of the company and any decisions that you make. Now, obviously this comes with greater personal risk, but some business owners prefer it this way. There is also a simplified tax reporting system for someone operating a DBA compared to some of the other styles of legal structure your business can utilize.