Choosing a legal structure for your small business

JohnTaylor November 18, 2012 0

Whether your small business is a partnership, a corporation or an LLC may not seem that important when it’s just a small hot dog stand or an online business that you and a friend are running from your mother’s basement, but if the business grows, having a proper legal organization can save you a lot of litigation and heartburn later.

The vast majority of businesses have three ownership options:

A privately-held business with a sole proprietor. In this form of business you are the sole owner of the business and all decisions regarding the business are your call. This is perhaps the most popular form of new small business ownership model. The advantages of the sole ownership model are that it is less expensive and easier in the start-up phase, as no attorneys will be needed to draft partnership agreements, all of the profits of the business will go to the owner and there is no possibility of challenges to your leadership from shareholder or partner lawsuits.

The main disadvantages of being the boss, are being the boss. In a sole proprietor business, you assume all of the risk, you have no one to share duties with unless you hire employees and the burden of all decisions rest upon your shoulders alone.

A privately-held business with shared ownership. This form of business has two or more partners sharing risk, decision-making and profits. This can be beneficial if you and a partner have complimentary skills that are vital to the success of your business, or if you or your partner have access to needed start-up capital. Partnerships can be tricky if there is friction among the partners or shareholders that result in leadership struggles or lawsuits.

When forming a privately-held partnership, clear roles need to be defined for each partner.  Deciding on ownership share and the rights and responsibilities of each partner is key to avoiding expensive legal conflict. When starting your partnership, engage an attorney to draw up partnership agreements that answer a number of questions including decision-making authority, dissolution of the partnership, buy-outs, and succession should one of the partners die or become unable to contribute to the business.

There are typically two types of partnerships, general partnerships, where each partner shares in liability and limited partnerships where there is one or more general partners and a number of limited partners whose liability is limited.

If your partnership involves minority shareholders, understand that they have avenues of appeal should they become disgruntled with how the business is being run.

Corporations. Corporations are free-standing legal entities, meaning that while shareholders may come and go, the corporation will continue despite changes in ownership. Most small businesses don’t start out as corporations, but eventually evolve into them as they grow. However, the corporation structure is advantageous to some start-up businesses, particularly the limited liability company version.

The advantages of the corporate structure is that it limits the liability of the principals (which is important if you’re pursuing a business likely to generate lawsuits), quick and easy transfer of ownership, the ability to raise capital by selling shares and certain tax benefits.

The disadvantages of forming a corporation are the costs involved in getting all the paperwork done and complying with regulations regarding corporations, the potential for shareholder lawsuits and certain tax disadvantages that occur in C corporations regarding dividends.

There are three types of corporations:

C corporations – This is the traditional corporation. This business structure is typically used by large businesses. The C corporation pays taxes as a free-standing legal entity and profits are taxed at the corporate tax rate. Profits paid as dividends to shareholders are taxed at individual income tax rates.

Subchapter S corporations – These corporations are more appropriate for small businesses. S corporations are limited to businesses with fewer than 75 shareholders and provide the liability protection to shareholders that the traditional corporation does. Profits from the S corporation are taxed as individual income as they are divided among shareholders.

Start-up businesses would do well to incorporate as S corporations, as losses from the business can be deducted against owners’ individual income.

A limited liability company – This is a form of partnership that is becoming increasingly popular. Limited liability companies are a type of hybrid between partnerships and corporations. The owners, called members, are limited in their personal liability for the debts and actions of the company, and the LLC provides tax and management benefits similar to those of partnerships.

When setting up a legal structure for your small business, be sure to hire a reputable, competent attorney to see you through the process. An attorney can explain the benefits and disadvantages of each type of legal structure and draft documents to address the particular needs of your partners or your business. Attorneys are absolutely necessary when forming a corporation, and are advisable to have when forming a partnership. Sole-proprietors of businesses may want to engage an attorney to help draw up documents regarding how the business will be disposed of should the owner die or become incapacitated.

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