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How to Choose the Best Legal Structure for Your Business

Thinking about turning your latest idea into a business venture? You’ll need to do some work to get it off the ground. One of your most important tasks will be to determine the best legal structure for the business.

We’ve unpacked the most common business structures available to US-based entrepreneurs, along with a handful of less-common structures. 

Read on to learn the basic attributes, advantages, and disadvantages of each structure and get some pointers on forming your business.

Why Your Business’s Legal Structure Matters

Choosing the right legal structure for your business is crucial. It affects everything from your taxes to your personal liability. For instance, it impacts how much you pay in taxes and what kind of funding you can secure. If you’re thinking long-term, consider how easy it will be to transfer ownership or bring in new partners. 

The right legal structure can set the stage for smooth operations and future growth, so it’s not a decision to take lightly. Take the time to understand your options and consult with a legal expert to make the best choice for your business.

We recommend Block Advisors for expert help forming your business. The company provides helpful online resources to educate you on types of business structures, including a quiz to choose the right structure and a calculator that shows how much you can save with an S Corp election.

Block Advisors’ business formation services start at $149. The team’s experts will prepare and file your documents with the state, ensuring accuracy and a quick turnaround time, and help you unlock potential tax savings.

Get $25 off Business Formation, online or in person at H&R Block using this link.*

Types of Business Structures

Here’s an overview of some common legal structures of businesses to help you determine which one is the best fit for your venture.

1. Sole Proprietorship

A sole proprietorship (sole prop) is the simplest and least formal business structure. By definition, it’s also the least conducive to growth. All sole props share some essential attributes:

  • Single Owner and Operator: A sole prop is owned and operated by one person only. Sole proprietors are free to hire employees and retain contractors, but they can’t add partners or issue stock to shareholders. 
  • No Formal Incorporation: Sole props aren’t formally incorporated as corporations or organized as partnerships. Ones that do business under a fictitious name, rather than the operator’s name, typically register those names with state authorities. These names are known as “Doing Business As” names (DBAs).
  • Tax Identification: If you’re your sole prop’s only employee, you can file taxes using your own Social Security number. If you hire employees, you’ll need to get an Employment Identification Number (EIN) from the IRS. This is free and takes a few minutes.
  • Separate Finances: Sole prop owners aren’t legally obligated to separate their personal and business finances. However, that can help you determine if your business is profitable, keep track of your income and expenses for taxes, and provide potential creditors with a precise accounting of your company’s finances. 
  • Pass-Through Taxation: Sole props don’t file taxes separately from their operators. As the owner of a sole prop, you’ll attach Schedule C or Schedule C-EZ (Form 1040) to your personal tax return. If your enterprise was profitable during the tax year, you’ll likely be liable for self-employment tax. You’ll report self-employment income and calculate self-employment tax on Schedule SE (Form 1040). 

Pros of a Sole Proprietorship

  • Simplicity. It’s super easy to set up a sole proprietorship. You don’t need to file articles of incorporation, draft an operating agreement, or make public financial disclosures. In many cases, you don’t even need to register a company name. 
  • No Double Taxation. Sole props are taxed on a pass-through basis, meaning your business income is combined with nonbusiness income for tax purposes. Your sole prop doesn’t pay taxes on business income that then passes through to you as taxable personal income.

Cons of a Sole Proprietorship

  • Personal Liability. The operator takes on personal liability for any debts or obligations incurred by the business. For instance, if you purchase equipment on credit and then find yourself unable to meet the vendor’s payment terms, the vendor may have the right to seize your personal assets.
  • Reticent Lenders. Unless your sole proprietorship has substantial assets to put up as collateral, it’s not likely to qualify for loans from traditional lenders. This is especially true for newer entities and owners with spotty personal credit. 
  • Potential for Greater Tax Liability. Sole props are taxed on a pass-through basis. When they’re profitable, they increase their owners’ total taxable income. A big enough increase in your taxable income bumps you into a higher tax bracket and raises your marginal rate, reducing your take-home pay proportionally. 

2. Partnership

Think of a partnership as a multimember sole proprietorship. Like sole proprietors, partners are personally liable for partnership debts and obligations. 

“Generally, partnerships do not require any filings with state agencies,”

says Shawn Toor, a business law attorney with Seattle-based Williams Kastner. “A partnership can be formed merely by the act of two or more people agreeing to carry on business and share in the profits and ownership control.”

Most partnerships are controlled by partnership agreements, which govern matters like the partnership’s legal name, term, initial contributions of each partner, and management duties. It also covers procedures for future contributions, admission of new partners, distribution of profits and losses, and voting.

You can find generic partnership agreement templates online and modify them to your partnership’s needs. However, these templates frequently leave out important eventualities. It’s wise to have an attorney draw up a customized partnership agreement on your behalf. 

There are three main types of partnerships:

  • General Partnership: A general partnership is the most common and straightforward type of partnership. Typically, general partners share equally in the partnership’s profits and liabilities, take on equitable duties, and have equal voting rights. The partnership agreement controls situations in which partners’ interests and duties diverge. 
  • Limited Partnership: An LP allows for a class of “limited partners” who function as passive investors. They are not personally liable for the partnership’s debts or obligations. And they receive profit or loss shares proportional to their interest, which is usually smaller than that of general partners.
  • Joint Venture: A joint venture is a time- and scope-limited general partnership. It’s ideal for one-off projects that require pooled resources, such as commercial real estate development. Partners in a joint venture can convert the enterprise into a traditional general partnership by amending the partnership agreement.

Pros of a Partnership:

  • Pooled Resources and Shared Responsibilities. Unlike sole proprietors, partners can pool resources without seeking outside investors or taking on debt. They can also share day-to-day management and executive decision-making responsibilities.
  • No Formal Incorporation Required. Most partnerships are governed by written, legally binding partnership agreements to which all partners consent, but these agreements don’t have to be reviewed by or filed with local or state authorities.
  • No Double Taxation. Partnership income is taxed on a pass-through basis. Partnership income is reported on Schedule K-1 (Form 1065), which the partnership must furnish to each partner by the annual deadline. Each partner adds his or her share of the partnership income, as reported on Schedule K-1, to his or her personal income from other sources.
  • Flexible Time Horizon. Partnerships don’t necessarily exist in perpetuity. If you need to pool your resources with other investors for a single project you can create a joint venture specifically for that purpose. When the project wraps up, the partnership dissolves, and you part ways.

Cons of a Partnership:

  • Personal Liability for Business Obligations. As with sole props, the greatest disadvantage of a partnership is personal liability for business debts and obligations. Your share of liability is proportional to your interest in the partnership–if you own 30% of the partnership, you’re responsible for 30% of its liabilities.
  • Potential for Greater Tax Liability. Like sole prop income, partnership income is treated as personal income. If your partnership is profitable, your personal income will increase, potentially raising your marginal tax rate, increasing your overall tax burden, and reducing your usable cash on hand.
  • Requires a Formal Agreement. Though partnerships don’t require formal articles of incorporation, virtually all are governed by partnership agreements. These contracts can be quite complex, and while it’s possible to modify a serviceable template at a low cost, it’s expensive to hire an attorney to draft a customized agreement.

3. Corporation (C-Corp)

A corporation, sometimes known as a C corporation or C-corp, is defined by the Small Business Administration as “an independent legal entity owned by shareholders… The corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.”

C-corps are subject to greater regulation than partnerships and sole proprietorships, with ongoing regulatory burdens, such as the requirement to hold annual shareholder and director meetings. 

Corporations must be formally incorporated with state business authorities, typically the Secretary of State office or equivalent. In addition to articles of incorporation, most corporations are governed by operating agreements or bylaws. Like partnership agreements, they’re not mandated by law, but they’re highly encouraged.

Unlike sole props and partnerships, C-corps are not pass-through entities. For tax purposes, they are treated as legally separate entities from their shareholders. 

Pros of a Corporation:

  • Limited Liability for Owners. As long as shareholder and business assets are kept separate, C-corp shareholders are not personally liable for the entity’s debts and obligations. They aren’t required to personally guarantee loans or purchases made on credit, and their personal assets can’t be seized to satisfy creditor claims.
  • Easier to Generate Capital. Corporations can raise capital by selling shares of stock (equity), unlike partnerships and sole proprietors, who face more challenges raising money. 
  • Greater Legitimacy. Incorporated entities appear more legitimate to lenders, vendors, and potential customers. This legitimacy can lead to loans approved at more favorable terms, discounts, or favorable credit arrangements on big-ticket equipment or inventory purchases.
  • Built-In Incentives for Employees. Equity is a powerful incentive for current and prospective employees. Corporations frequently reward performance, longevity, and other value-adds with stock or stock options, attracting high-quality employees and incentivizing them to stick around.

Cons of a Corporation:

  • Potential Tax Disadvantages. C-corps’ shareholder distributions are effectively taxed twice: once at the corporate level, before distributions are made, and again as personal income on shareholders’ personal tax returns. 
  • Expensive and Cumbersome to Form. C-corps are expensive and cumbersome to form. Proper incorporation requires substantial legal and financial assistance, especially in heavily regulated industries.
  • Greater Regulatory Burden. Even privately held corporations are subject to greater regulatory burdens than partnerships and sole proprietorships. If insulation from personal liability and greater capital-generation potential don’t outweigh these considerations, look to a lower-key business structure.

4. S Corporation (S-Corp)

An S corporation, also known as an S-corp, is a special type of incorporated entity that’s ideal for small to midsize businesses. Like C-corp owners, S-corp owners and shareholders are insulated from personal liability for business debts, obligations, and actions. 

Unlike C-corps, S-corps are pass-through entities. Their income isn’t subject to corporate income tax – it passes through as distributions to shareholders, who then pay personal income tax at an appropriate rate.

Incorporating and operating an S-corp is an intensive process. Like C-corps, S-corps require articles of incorporation filed with the appropriate authorities, as well as annual shareholder meetings. Operating agreements are also strongly encouraged.

S-corps have a few noteworthy twists:

  • S Corporation Election: After incorporating, all shareholders must sign and file IRS Form 2553, Subchapter S election. This establishes the corporation as a pass-through entity subject to certain restrictions. 
  • Shareholder Compensation: S-corp shareholders who also work as employees must take “reasonable compensation” (salary taxed as wage income) in addition to their profit distributions.
  • Shareholder Restrictions: By law, S-corps can have only 100 shareholders. The potential pool of shareholders is restrictive as well: S-corp shareholders must be U.S. citizens and (in most cases) human beings. With rare exceptions, S-corps can’t be owned by other businesses or legal structures, such as trusts.
  • Stock Restrictions: Unlike C-corps, which can issue common and preferred shares, S-corps can only issue common stock. Common shares represent equity stakes and confer voting rights, widening the pool of shareholders with sway over the company’s decision-making processes.
  • Uneven State Tax Treatment: According to the SBA, S-corps are treated uniformly under the federal tax code, but they’re subject to varying treatments at the state level. While most states recognize S-corps as pass-through entities, some tax S-corps’ profits and shareholders’ income from said profits. 

Pros of an S Corporation:

  • Limited Liability for Owners. As an S-corp shareholder, you’re not required to personally guarantee loans made to the business or expose personal assets to creditor seizure.
  • No Double Taxation. Like sole proprietorships, S-corps are pass-through entities. Unlike C-corps, S-corps are not subject to corporate income tax. By extension, S-corp shareholders are permitted to deduct their firms’ losses, if any, from their personal income.
  • Easier to Raise Capital. As corporations, S-corps can raise capital by selling stock. Though they’re permitted to issue common stock only, they still have more flexibility to raise capital on favorable terms than sole proprietorships and partnerships.
  • Greater Legitimacy. Like C-corps, S-corps are incorporated entities, with all the legitimacy that entails. However, S-corps aren’t ideal for institutional investors, so you may need to reincorporate down the line before seeking outside equity funding.

Cons of an S Corporation:

  • Size of Ownership Class Is Limited. S-corps can’t have more than 100 individual (human) shareholders. If you need to raise lots of capital from a wide investor pool, C-corp status is a better fit.
  • Potentially Expensive to Incorporate and Operate. Like C-corps, S-corps are expensive and cumbersome to incorporate. They have high ongoing operating costs and burdens, such as the annual shareholder meeting requirement. And S-corp shareholders have to worry about another wrinkle: the annual Subchapter S election. C-corp shareholders can disregard that one.
  • Reasonable Compensation Requirements. Since wage income is taxed at a higher rate than the “reasonable compensation” requirement, this raises S-corp shareholder-employees’ overall tax burden.

5. Limited Liability Company (LLC)

“LLCs are hybrids between corporations and a partnership,” says Toor. “LLC members have the same rights and limited liability of shareholders in a corporation, and LLCs themselves have the added benefit of being treated like a partnership for tax treatment.”

According to the IRS, LLCs can be classified as corporations, partnerships, or sole proprietorships for tax purposes. By default, single-member LLCs are treated as disregarded entities, with pass-through business income recorded on members’ personal tax returns (Schedule C or C-EZ). 

LLCs with two or more members are treated as partnerships, regardless of the number of members. However, any LLC can elect to be treated as a corporation for tax purposes. 

Like C-corps and S-corps, LLCs are required by law to file articles of incorporation with the appropriate state authorities. Operating agreements are strongly encouraged as well. 

According to the SBA, state law often leaves LLCs vulnerable to member losses. Capable business attorneys can draft detailed operating agreements that account for common (and not-so-common) eventualities.

“The main difference between an LLC and S corporation is operational flexibility,” says Brian Thompson, a Chicago-based CPA and business attorney. “LLCs are not subject to the requirement of an annual shareholders’ meeting or annual directors’ meeting.”

Pros of an LLC:

  • Limited Liability for Owners. Like S-corp and C-corp shareholders, LLC members are not personally liable for the enterprise’s debts and obligations.
  • Lower Regulatory Requirements. Compared with S-corps and C-corps, LLCs have more manageable regulatory requirements. While articles of incorporation are required and operating agreements strongly encouraged, ongoing record-keeping and reporting requirements aren’t as onerous.
  • Can Avoid Double Taxation. As pass-through entities, LLCs aren’t subject to corporate income tax.
  • Can Request S-Corp Status for Tax Purposes. Like C-corps, LLCs can request S-corp status by filing a Subchapter S election within the first two months and 15 days of the tax year. Depending on the entity owners’ duties and employee status, this can lead to a more favorable tax situation for shareholders.
  • Corporations and Other Entities Can Be Shareholders. Unlike S-corps, LLCs don’t restrict membership to human beings. Corporations, trusts, partnerships, and other legal entities can own shares in LLCs. 

Cons of an LLC:

  • Members Are Considered Self-Employed. For tax purposes, LLC members are considered self-employed. Like sole proprietors, they’re on the hook for self-employment tax – the employer’s share of Medicare and Social Security tax.
  • Potential for Greater Tax Liability. If your LLC income is taxed on a pass-through basis, you can avoid double taxation. However, if the enterprise is profitable, you may still find yourself subject to a higher marginal rate and greater overall tax burden.

How to Start Your Business

There are a few additional steps to take when you’re ready to start your business.

The Small Business Administration‘s 10-point checklist for budding entrepreneurs is a great place to start. It ticks off a list of crucial to-dos for anyone in the early stages of business formation:

  • Brainstorm and write your business plan
  • Look for assistance and training in your industry or area of expertise
  • Choose a business location (domicile and physical location, if you’re not working out of a home office or coworking space)
  • Find startup financing for your small business
  • Determine your company’s legal structure and set up your business with a company like Block Advisors
  • Register your business name (“Doing Business As”)
  • Get a tax identification number and ensure you’re in compliance with local, state, and federal tax regulations
  • Get a business license and permits, if required
  • Learn your obligations vis-a-vis hiring employees, including responsibilities under the Fair Labor Standards Act and what to do if an employee files an FLSA complaint against you
  • Find local assistance from the SBA and local business resources

Additionally, we recommend that you keep looking for ways to reduce your small business expenses. That’s more of an ongoing obligation, but its importance is impossible to overstate, and it’s never too early to get started.

In any event, number five on that list (determining your company’s legal structure) is crucial, with plenty of pitfalls to avoid.

*Discount may not be combined with any other offer or promotion. Available virtually and at participating locations. Void if transferred and where prohibited. Discount will appear in your cart automatically when you use the link. No cash value.

Grant Sabatier is a co-founder and CEO of MMG Media Group, which owns Grant is also the Creator of Millennial Money and Author of the International Bestseller Financial Freedom (Penguin Random House), which has been translated into fifteen languages. Dubbed the “Millennial Millionaire” by CNBC, Grant went from $2.26 to a millionaire in 5 years, reaching financial independence at the age of 30. Grant has been featured in The New York Times, The Washington Post, NPR, BBC, CNBC, Forbes, Business Insider, Money Magazine, The Wall Street Journal, Marketwatch, the Rachael Ray Show, and many others. He cares passionately about sharing his story to inspire others to build a life they love, reminding everyone that time is more valuable than money, and building cool stuff.
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