A business entity refers to an establishment created by one or more persons to undertake a particular business or facilitate involvement in commerce or analogous activities. Often termed business structures, these entities are established at the state level by submitting requisite documentation to a state governing body, such as the Secretary of State.
When starting a business, one of the most crucial decisions you have to make is choosing the right legal structure. The choice will impact your taxes, liability, paperwork, control, and various other aspects of your business. This blog post is your comprehensive guide to understanding legal business entity formation and making the right choice for your venture.
What is a business legal structure?
A business legal structure, or entity, is the legal form under which a business operates. It defines how the business is organized, how it is owned, how profits and losses are shared, and the legal responsibilities of the business owner(s). Common business legal structures include sole proprietorships, partnerships, limited liability companies, corporations, and cooperatives.
Business entity formation involves selecting the right legal entity, preparing and submitting the necessary paperwork to the appropriate government agency, obtaining required licenses or permits, and paying applicable fees. Depending on your business’s needs and goals, you may also need to consider other factors such as taxation methods, funding sources, or operating procedures.
Why is a business legal structure important?
When starting a business, one of the many critical decisions you will make is selecting the appropriate legal structure. The choice of a business legal structure, sometimes referred to as a registered business entity, significantly impacts how your business operates and grows.
Taxes: Tailored Tax Benefits
Different business structures are subject to different tax regulations, including state and federal income taxes provisions. By choosing the right structure, you could potentially lower your tax liability. For example, a sole proprietorship and a partnership allow profits to pass through directly to the owners’ personal income without facing corporate taxes. On the other hand, corporations are taxed at the corporate level, and shareholders pay taxes on dividends, known as double taxation.
Certain structures may allow for more deductions and tax credits than others. For instance, an S corp doesn’t pay corporate income taxes. Instead, the company’s income or losses are divided among and passed through to its shareholders.
Liability: Protecting Personal Assets
The legal structure determines whether your assets are at risk if the business faces lawsuits or debts. For example, in a limited liability company (LLC), the owner’s assets are generally protected from business debts and claims. In contrast, a sole proprietorship does not offer this protection; the owner’s assets can be used to settle business debts.
Therefore, choosing the right legal structure is essential to ensure that your personal assets are protected in case of any litigation or financial problems.
Paperwork: Compliance and Administration
Different business structures require different levels of compliance and administrative work. A sole proprietorship usually requires less paperwork compared to a corporation which may need to file annual reports, hold annual meetings, and maintain corporate records.
When selecting a business entity, consider the amount of paperwork involved. If you are looking for an entity requiring minimal paperwork and compliance, then a sole proprietorship or limited liability company may be the right choice.
Hierarchy: Management Structure
The legal structure of a business affects its management hierarchy. Corporations, for example, require a board of directors who make major business decisions, while in an LLC, the owners have more direct control over business decisions.
In partnerships or LLCs, decision-making can be more fluid, whereas, in corporations, it is usually more structured and formalized. Understanding how you want to conduct business operations will help you choose a structure that aligns with your management style.
Registration: State and Federal Obligations
Depending on the structure you choose, your business may have different registration requirements at the state and federal levels. Corporations and LLCs, for instance, usually need to be registered with the state and comply with more regulations than sole proprietorships.
Before you decide on a legal structure, ensure you understand your chosen entity’s registration requirements and any other obligations. The legal body in each state has specific rules and regulations that your business must comply with, so make sure you are familiar with these.
Fundraising: Attracting Investors
Certain structures are more appealing to investors. If you plan to raise capital by selling stock, a corporate structure would be more appropriate. Additionally, venture capitalists usually prefer investing in corporations, particularly C corporations.
The structure of your business can also impact your ability to secure business credit facilities. Depending on your business structure, banks and other lending institutions may have different requirements or preferences.
Types of business structures
When you’re in the early stages of launching a business, one of the most critical decisions you will need to make is choosing the legal structure for your company. This decision will significantly affect your liability, how you raise capital, the paperwork you need to file, and how you can distribute profits. Understanding the differences between the various business structures is key to making an informed decision. Below are the commonly used business structures.
A sole proprietorship is the simplest form of business structure. It’s designed for single-owner businesses. In a sole proprietorship, there’s no legal distinction between the owner and the business. This means the sole proprietor is entitled to all profits but personally liable for all the business’s debts, losses, or legal liabilities. Because of its simplicity, a sole proprietorship is popular among individual self-contractors, freelancers, and small business owners.
Some examples are listed below:
A partnership is a business structure in which two or more individuals manage and operate a business in accordance with the terms and objectives set out in a Partnership Agreement. Partnerships come in two forms: general partnership (GP) and limited partnership (LP). In a general partnership, partners divide responsibility for management and liability and share profits or losses. Limited partnerships allow partners to have limited liability and limited input in management decisions, which are determined by their investment percentage.
Here are some examples of partnerships that have been successful:
Ben & Jerry’s
Limited Liability Company
A Limited Liability Company (LLC) combines partnership and corporation elements. This structure provides the limited liability features of a corporation but the tax efficiencies and operational flexibility of a partnership. Owners of an LLC referred to as members, are protected from personal liability for the debts and obligations of the LLC, similar to the protections afforded to shareholders of a corporation.
Here are some other well-known examples of limited liability companies (LLCs):
A corporation is a more complex legal structure considered separate from its owners. This means that the corporation, not the shareholders, holds legal liability for all its actions and debts. Corporations can raise capital through the sale of stocks, which entitles the shareholders to a portion of the profits. Corporations pay income tax and distribute earnings to shareholders. There are several types of corporations, including C corporations, S corporations, B corporations, close corporations, and nonprofit corporations.
C corporations: Often, the choice of large companies is due to allowing unlimited investors. C corporations are separate taxable entities owned by shareholders, like JPMorgan Chase & Co., Bank of America, Apple, and Amazon.
S corporations: Tailored for small businesses, an S corporation averts double taxation similar to partnerships and LLCs and offers limited liability protection, exemplified by Widgets Inc.
B corporations: Known as benefit corporations, B corporations blend profit-making with positive societal impact. The Body Shop is a prime example due to its dedication to environmental and social causes.
Closed corporations: Characterized by a small number of shareholders and not being publicly traded, closed corporations like Hobby Lobby enjoy limited liability protection and operational flexibility.
Open corporations: With shares available to the public, open corporations like Microsoft and Ford Motor Co. are widely owned and allow anyone to invest.
Nonprofit corporations: Serving a charitable or social purpose rather than pursuing profit, nonprofit corporations like the American Heart Association, Salvation Army, and American Red Cross are rewarded with tax-exempt status.
Some popular corporations are listed below:
Exxon Mobil Corp.
A cooperative is a business structure owned by the people who use its services or those who work there. It operates for the benefit of its members. These members could be part of the business as employees or customers using the business’s services and sharing the profits. This business structure is commonly used in agriculture, retail, and service industries.
There are other co-ops worth mentioning as well:
Navy Federal Credit Union
Factors to consider before choosing a business structure
Selecting the right business structure is pivotal in laying the foundation for your business. The structure you choose affects your taxes, liabilities, and operations. Considering various factors before making this choice ensures the structure aligns with your business objectives and requirements. Here’s a breakdown of factors to weigh as you choose the appropriate structure for your business.
When setting up a business, it is important to consider how adaptable the structure is. For instance, if your business is likely to evolve quickly, you may need a structure that can easily accommodate changes in management style, capital structure, or business operations.
Different structures offer varying levels of flexibility in decision-making. For instance, in a sole proprietorship, decisions can be made swiftly by the owner, whereas, in a corporation, the decision-making process might be slower and involve a board of directors and shareholders.
Managing Operational Intricacies
The complexity of your business structure should reflect the nature of your operations. For a small business or a startup, a less complex structure like a sole proprietorship or LLC is often suitable. However, as a business grows, its operations may become more complex, and a corporation might be more appropriate.
Handling Legal Formalities
It is also essential to consider the legal formalities associated with each structure. While a sole proprietorship has minimal legal formalities, a corporation has several, including annual meetings, reports, and more extensive record-keeping.
Protecting Personal Assets
One of the critical aspects to consider is your willingness to expose your assets to business liabilities. Structures like sole proprietorships and partnerships have unlimited liability, whereas LLCs and corporations provide liability protection.
Assessing Business Risks
If your business is inherently risky, or if there’s a likelihood of facing lawsuits, considering a structure that offers liability protection, like an LLC or corporation, can shield your assets.
Understanding Tax Obligations
Different business structures have different tax implications. It’s crucial to understand how these taxes will impact both the business and your personal financial situation.
Maximizing Tax Benefits
Selecting the right structure can also help maximize tax benefits. For example, S corporations allow business profits and losses to be passed through to shareholders’ income without facing corporate taxes.
If maintaining control over your business is a priority, this will influence the structure you choose. Sole proprietorships offer maximum control, while a corporation might involve sharing control with a board and other shareholders.
Managing Internal Operations
The structure also affects the daily operations and management style. A more hierarchical structure, like a corporation, requires a more formalized management style, while an LLC or partnership allows for more direct control over operations.
Your business structure can affect your ability to raise capital. For example, if you plan to raise capital through equity financing, a corporation generally makes it easier to issue shares of stock.
Certain investors may prefer to invest in specific business structures. Venture capitalists, for instance, are often more inclined to invest in corporations.
Licenses, Permits, and Regulations
Meeting Legal Requirements
Each business structure has its own licenses, permits, and regulations that must be followed. Understanding and ensuring that your business can comply with these is crucial.
Navigating State Regulations
It’s also important to recognize that these regulations can vary by state. A particular business structure might be more advantageous in one state than another, so it’s important to investigate the specifics of your location.
How Can Moton Legal Group Help?
While this guide gives you a general understanding, legal business entity formation can be complex and varies by state and industry. Moton Legal Group, a team of seasoned business attorneys, can assist you in navigating these complexities. From advising on the right business structure to assisting with registration and ensuring compliance with regulations, Moton Legal Group can be a valuable ally in setting up your business on a solid legal foundation.
Frequently Asked Questions (FAQs)
How are entities formed?
The process of forming a business entity involves several steps, including choosing a business structure, registering your business name, obtaining necessary licenses and permits, and fulfilling state-specific legal requirements such as filing articles of incorporation for corporations or articles of organization for LLCs.
What is the importance of business formation?
Proper business formation is essential for setting the foundation of your business. It determines your tax obligations, legal liabilities, ability to raise capital, and day-to-day operations. Getting it right from the beginning can save you time, money, and legal troubles down the road.
What are the basic forms of business formation?
The basic forms of business formation are sole proprietorship, partnership, corporation, limited liability company (LLC), and cooperative.
Choosing the right legal structure for your business is a decision that should be made with careful consideration of the factors outlined in this post. It’s advisable to consult with legal and financial advisors to understand the implications of each structure based on your business goals and needs. Your choice will have a lasting impact on how your business operates, how it is taxed, and your personal liability, so it’s important to make an informed decision. By considering your options carefully and possibly seeking expert advice, you can establish a legal foundation to support your business in the coming years.
Business Formation Law also sets forth guidelines for handling disputes between shareholders, partners, or other stakeholders in a company. It outlines various provisions related to fiduciary duties of directors and officers, as well as rules pertaining to ownership of the company and its assets. In addition, it includes provisions related to corporate taxes, intellectual property rights, employee benefits, and other important matters. Finally, Business Formation Law can address issues related to liability protection for business owners or directors in the event of a lawsuit or claim against the company.