CHAPTER EIGHT: Part E – Are you in the process of starting a business? How do you plan your business legal structure? What is the legal structure of a business plan? Well, I advice you read on to learn how to legally plan your business structure.
In case you are wondering where your business belongs, here are some common definitions:
- Sole proprietorship: A business that is owned and run by a single individual
- Partnership: A business created and sustained by the joint efforts of two or more individuals
- Corporation: A business that enables prospective shareholders to exchange money or property for capital stock
A business legal structure is a very important component of a business plan. When beginning a business you must decide what legal structure your business will assume. The most common business structures are sole proprietorship, partnership, C Corporation, and S Corporation.
Your chosen structure determines which income tax return form to have to file. Making a final decision as to which legal structure your business would assume could be very tricky because each option has its own pros and cons. Now, let’s discuss each of these types of business structures.
Writing a Business Plan – How to Plan Your Legal Structure
1. Sole proprietorship
A sole proprietorship refers to a business that is owned by one individual. Most businesses, especially small businesses are sole proprietorships by default unless they are stated to be otherwise. The owner of a sole proprietorship is expected to report all business profits and losses on their personal tax returns. This is because a sole proprietorship is not taxed separately.
Keep in mind, however, that by being a sole proprietor, you have unlimited liability to the business as well as its debts. This implies that if you happen to be sued (or you have problems with paying up your debts), your personal assets (your house, cars) will be at risk; alongside your business assets.
So, while a sole proprietorship has the advantage of not being taxed separately, it has the disadvantage of making you lose more than you can ever imagine should you run into debt or legal hassles.
2. LLC (Limited Liability Company)
This business structure was not widely known until recently. And now, it has become the most popular way for small businesses to get started. Although an LLC is taxed just like a sole proprietorship, it has the added advantage of a limited protection of a corporation. Because the LLC is a fairly new addition to the business legal structures, you need to find out if your state or country’s business laws recognize LLCs.
As an LLC owner, you can use losses to offset income but only up to the amount you invested and not more. And in case you run into problems, your personal assets have more protection than in the case of a sole proprietorship. (But this protection is not 100%). However, one disadvantage of LLCs is that they are usually subject to additional state or franchise taxes.
3. C Corp
A C Corporation is a taxable entity; it is taxed solely on its income rather than the owner being taxed. This offers a big advantage to the owner in that a C Corp can use an “income splitting” strategy to divide the profit realized from the business between the company and its owners.
This means part of the tax obligations are due on the corporation itself and the remaining part id taxable to the owners. This strategy could put both the company and the owner into lower tax brackets for tax savings.
But C Corps can be subject to double taxation on dividends paid out to shareholders, and this is the main disadvantage of this legal structure. When this happens, the corporation is taxed on the its income while the shareholders are also taxed on their dividends.
4. S Corp
An S Corp doesn’t have to pay self-employment taxes on its income. So, this legal structure can provide some tax savings. But S Corporations are required to pay owner-employees a “reasonable salary” before they can pay out any dividends to shareholders.
However, the reasonable salary paid is subject Social Security and Medicare fees, both of which would sum to self-employment tax most of the time. S Corps can only enjoy significant tax savings when the company becomes a big income earner. Like C Corps, S Corps are intricate and cost more attorney and accountant fees at the time of tax.
To find the best legal structure for your business, search the web for more resources that give an in-depth explanation of the pros and cons of each option. Then assess your business to understand which option seems to be most suitable for it.
If you are having problems with choosing the most suitable legal structure for your business, you can consult a seasoned business lawyer or CPA (Certified Public Accountant) to help you decide which is right for you.
While an attorney would help you protect your personal assets by helping you choose the right structure, an accountant would determine tax-reporting responsibilities for your chosen legal structure.
In conclusion, after deciding on the right legal structure for your business, you should educate yourself regarding your rights and responsibilities as a business owner. To know more about these, you can consult your local SBA (Small Business Association) or (IRS) Internal Revenue Service.