At a certain point, every business owner has to decide which legal structure is best for their company. Here are the pros and cons of each type of business organization:
- Sole Proprietorship
- Limited Liability Company (LLC)
Choosing the right legal structure will help you reduce personal liability, access proper capital investment, lower your company’s tax burden and avoid unnecessary regulatory requirements.
A sole proprietorship refers to the person who owns a business and is personally responsible for its debts and liabilities. Anyone who has not formed a legal structure and does business as a freelancer or contractor is considered a sole proprietor. Although this does not form a separate legal entity, the sole proprietorship is still responsible for complying with all applicable registration, license, and permit laws.
- Owners may commingle company and personal assets
- Sole proprietorships are simple to setup and nominally expensive
- Earned income may be offset from losses from other sources
- Sole proprietors have complete authority on decision making
- The company is easy to dissolve
- Owners cannot sell an equity stake to raise capital for the company
- Sole proprietors have unlimited liability and are responsible for all debts and obligations of the business
- Hiring quality employees is more difficult because ownership of the company cannot be shared
- Some benefits, such as health insurance premiums, are not directly deductible from business income
For these reasons, most entrepreneurs will want to graduate their company from a sole proprietorship to a more formal business legal structure.
A partnership is formed when two or more people start a business with a goal of making a profit. No legal documentation is required to form a partnership, although it is highly recommended that a partnership agreement is created.
Whether or not there is a partnership agreement in place, I highly recommended that all partners openly discuss all aspects of the company, including:
- the business plan
- expected partner capital contributions
- profit and loss distribution plans
- management and hiring
- exit strategy
- internal disagreement resolution
Because of the power each partner has over the partnership, avoiding and efficiently handling disagreements is critical for the success of the group.
- Partnerships are easy to establish
- Hiring quality employees is easier, because new employees can be given a share of the business
- Taxation is simple. Partnerships are ‘pass through’ entities, meaning each partner individually pays taxes on their share of distributions
- State and federal filing requirements are low, relative to a corporation
- Each partner is liable for the debts and obligations of the business
- Profits must be shared
- Because each partner is liable for actions of other partners, disagreements can occur
- Each partner can legally commit others to a business contract
- Some employee benefits may not be able to be deducted on income tax returns
- General partnerships have limited ability to raise capital
Once the benefits of a partnership no longer outweigh the risks, many Entrepreneurs choose to form an LLC or Corporation. In fact, most provisions in a partnership agreement can be replicated in the operating agreement of an LLC. Becoming an LLC allows partners to reduce risk personal risk, without having a significant impact on the day to day operations.
If it is decided that a partnership should be kept in place, you should consider insuring the partnership to cover potential debts or liabilities.
Limited Liability Company (LLC)
Many small and medium business owners structure their company as an LLC. To setup an LLC you must:
- Choose a business name
- File articles of organization
- Pay the filing fee
- Create an operating agreement
- Some states require you publish a notice of your intent to form an LLC (Arizona and New York)
- Obtain licenses and permits
- Limited liability for partners
- No double taxation – earnings and losses pass through to the owners
- No limit on number of shareholders
- Any member or owner can be involved with the operations of the LLC (unlike a Limited Partnership)
- Fewer filing and administrative requirements than a corporation
- Some states require that an LLC dissolves after 30 years
- Some states require that the LLC dissolves after a member dies or quits
- LLCs have higher regulatory and filing requirements than a sole proprietorship or partnership
A corporation is much more complex and expensive to set up, but allows shareholders to separate company debts from personal assets. The corporation is legally considered an independent entity that is separate from its owners.
- Liability protection for owners of the corporation
- Personal assets of owners are not at risk to creditors
- A corporation can retain profits without the owners paying tax
- A corporation has higher capability to raise capital and offer different levels of stock
- Corporations are not required to dissolve after a certain period of time
- Corporations are not required to dissolve after a owner dies or quits.
- The filing and administrative requirements are higher than other types of business organizations
- Corporations often have higher overall tax rates
- Shareholder dividends are not tax deductible for the corporation
- Income is taxed twice – at the corporate tax rate and again at the individual income tax rate
- Federal, state, and many local agencies monitor corporations and often have different regulatory requirements, ultimately increasing compliance costs.
- S-Corps are limited to 100 shareholders and may only have one class of stock
A common approach corporations take to manage double taxation is to pay shareholders of the company ‘reasonable’ compensation in the form of a salary. These costs can be deducted as a business expense, but the IRS monitors this closely and will result in significant fines if done incorrectly. It is very important to have a trusted legal team in place to reduce your tax burden and keep your corporation in good standing with all regulatory authorities.