June 8, 2022
Reading Time: 9 minutes
Choosing a legal structure for your business is a big decision. No matter what stage your business is at, it’s essential to know what the options are, how they differ, and why they matter. This article summarizes the most common legal structures for small businesses and includes resources that can help you with the incorporation process.
If you need personal advice on choosing the proper legal structure for your business, reach out to email@example.com and schedule a free consultation with a Hansa expert (in English or Spanish) at your earliest convenience.
Types of business structures
A sole proprietorship is a business structure where all company profits and debts are tied to a single person. A sole proprietorship gives you complete control over your business as an owner.
- Easy setup: With no partners to account for, there is very little paperwork, which makes it the least expensive structure
- No profit-sharing: Since the owner is in complete control of the company, she receives all of the profits
- No double taxation: The IRS does not view a sole proprietorship as a separate legal entity. This means that the business itself does not pay income taxes. The business earnings pass directly to the proprietor, and the proprietor must report those earnings on their personal tax forms
- Easy exit: As a single owner, you can fold your business at any time with no formal paperwork. All you have to do is cease your operations, including your advertising
- Personal assets are not protected: The business owner assumes unlimited liability. That is, there is no separation of the owner’s personal and professional assets, which means personal assets (such as the owner’s car, home, and savings account) may be at risk if the business goes bankrupt or faces legal action
- Harder to find providers: Many enterprise providers (financing, software, POS, etc) cannot work with sole proprietors, so owners may have a more challenging time signing up for business products and services
- Low-risk businesses and owners who want to try out a business idea before creating a more formal business
A partnership is a company owned by two or more individuals. There are two types of partnerships: general partnerships and limited partnerships. Under a general partnership, all partners have an equal say in running the business. Furthermore, all partners are fully liable for the company’s obligations, which means they all put their personal assets on the line.
Under a limited partnership (a partnership with at least one general partner and one limited partner), limited partners do not assist with running the business and are only liable for the amount of their investment, which means their personal assets are protected.
- Easy setup: There is very little paperwork involved in filing for a business partnership
- More fundraising potential: With more than one owner, financing providers can consider multiple credit histories, which means you’re more likely to be approved for business loans
- No double taxation: As with sole proprietorships, partnerships are not viewed as separate legal entities by the IRS. This means that the LLP itself does not pay income taxes. The business earnings pass directly to the partners. Each partner or member must then report their share of profits on his or her personal tax forms
- Limited liability for LPs: Under an LLP, limited partners have limited liability for the company’s obligations. If the company goes bankrupt or faces legal action, the LP’s personal assets are not at risk
- Additional fees: This structure is more expensive than a sole proprietorship because it requires an Articles of Partnership agreement (a document that an attorney has to review)
- Personal assets are not protected for GPs: The general partner faces unlimited liability (no separation between the person and the business), so personal assets may be at risk
- Shared liability: You may be held liable for decisions and actions that your business partner took
- Profit sharing: Profits must be shared among the partners. If the partnership agreement is not clear about how profits should be shared or how decisions should be made, the business can suffer
- Multi-owner businesses, groups of professionals (such as lawyers), and groups that want to test out a business idea before forming a more formal company
Limited Liability Company (LLC)
LLCs are similar to partnerships in various respects. However, unlike partnerships, an LLC does not require a general partner, and all owners enjoy limited liability.
- Limited liability: All members are protected from personal liability under an LLC. In most cases, if the company goes bankrupt or faces legal action, personal assets are not at risk
- No shared liabilities: Partners are not liable for the actions or decisions of other partners
- No double taxation: Profits and losses can be reported on your personal tax forms without facing corporate taxes
- Ownership transfer: In many states, LLCs have a limited duration. To transfer ownership, when a member enters or leaves the LLC, some states require the company to dissolve and re-establish itself with the new members
- Profit sharing: Profits must be shared among members. If the LLC agreement is not clear about how profits should be shared or how decisions should be made, the business can suffer
- Medium- to high-risk businesses, owners with significant personal assets they want to protect, and owners who wish to pay a lower tax rate than a corporation
Corporations (C-Corp and S-Corp)
Corporations are legal entities separate from their owners. The corporation itself can sue and be sued, issue shares, make profits, pay taxes, own and sell property, etc. Unless otherwise stated, the pros and cons mentioned below apply to both C-Corps and S-Corps.
- Limited liability: Shareholders are not responsible for the debts of the corporation; they are only liable for their investments
- Ownership transfer: Shareholders can sell their shares to transfer ownership of the company. With a corporate structure, your business continues to operate after a transfer of ownership
- More fundraising potential: Since you can issue shares, it’s much easier to raise capital from multiple investors when your business is incorporated
- No double taxation (S-Corp only): Much like partnerships and LLCs, S-Corps avoid corporate tax rates by reporting profits, and some losses as the owner’s personal income
- Double taxation (C-Corp only): Unlike sole proprietorships, partnerships, and LLCs, C-corps pay taxes on their profits. In some cases, corporate profits are taxed twice: first on corporate tax returns (when the company makes a profit) and then on personal tax returns (when the profits are distributed to shareholders as dividends)
- Higher administrative costs: Corporations are required to have annual meetings, notify shareholders of important decisions and events, keep transcripts of meetings, etc
- Medium- to high-risk businesses that need to raise money and plan to "go public" or be sold over time
Knowing about legal structures is crucial whether your business is just starting out or growing. After all, your business's legal structure can affect your taxes, liabilities, paperwork needs, and fundraising. If you are not sure how to choose the right legal structure for your business, reach out to firstname.lastname@example.org - we can help you for free!