How To Choose a Legal Structure for Your Business — Which Business Structure Makes Sense? Almost every product purchased is backed by a corporation or LLC, and as such, most people know what a corporation is; however, not everyone knows whether one is needed when starting a business.
There are several key factors to consider when choosing your business structure. Annually, there are millions who decide to file for corporation status, and there are likely just as many who decide it is not required for the type of business they intend to own and operate.
BUSINESS STRUCTURE
Starting a new venture – whether as a candlemaker who sells products on Etsy or as a bookkeeper can easily be established with sole proprietorship.
SOLE PROPRIETORSHIP: A business operated by an individual person without the protection of a legal entity.
You can operate your business under your own name, or you can create a fictitious business name and do business as that fictitious business name:
FICTITIOUS BUSINESS NAME (FBN)1: Any name used for business (also sometimes called a trade name) that doesn’t contain the legal name of the owner/sole proprietor.
DOING BUSINESS AS (DBA): A situation in which a business owner operates a company under a name different from its legal name.
The owner must file a fictitious name statement, dba statement, or an assumed name statement with the appropriate agency, for example, the county clerk or secretary of state, that records the names of the business’s owners.
This enables customers to discover the names of the business owner(s), which is important if a consumer has an issue or needs to sue the business.
- Example: Crafty Crumbs Bakery could be a fictitious business name for Jane Smith. She isn’t using her legal name, she has created a “brand name,” and as a sole proprietor, she can now establish a business banking account and accept business and operate under this brand.
With the FBN created and certified properly, Jane Smith can:
- Open a business account under the name Crafty Crumbs Bakery
- Acquire a business license and business insurance for Crafty Crumbs Bakery
- Receive checks from her customers made out to “Crafty Crumbs Bakery”
- Establish trade accounts and credit accounts for Crafty Crumbs Bakery
However, every item listed above would still be signed, secured, or endorsed by Jane Smith,
the legal owner and sole proprietor of the business.
The FBN or DBA simply represents Jane Smith is doing business as Crafty Crumbs Bakery.
Alternatively, Jane could decide to do business using her own name and not create a brand name.
She could still file for a business license and establish her business while using her name, Jane Smith.
Whether you operate under your legal name or an FBN, as a sole proprietor you are personally liable for the business risks, such as financial risk, liabilities acquired for the business, and any injuries caused by the business or that take place at the business site or that arise out of any normal business operations.
Utilize business insurance, such as commercial and general liability policies to protect your personal assets. This can cover business risks and help you avoid liabilities that could incur a risk to you personally.
Numerous new businesses will start as a sole proprietor and utilize business insurance for some protection over their personal assets.
INCORPORATION (LLC OR CORPORATE)
Two main reasons to consider whether forming a corporation is right for your business are:
1. To form joint ownership – allows business owners/merchants to share ownership or expand to take on investors and shareholders who are not involved in the day-to-day operations, and spreads financial risks and rewards across the multiple owners (joint ownership other than a spouse)
2. To limit liability – all owners would split the business risks and protect one person from shouldering all those potential burdens.
Establishing a corporate entity separates the risk of the business from the owners of the business.
Shareholders do not have personal liability for the conduct of the business owners, and this is the same for small-business owners who own all the stock in a company.
However, many new businesses choose not to incorporate due to the associated costs, such as:
– Costs to form the entity
– Annual maintenance fees
– Tax filing by an accountant for the entity
– Additional CPA fees to file taxes annually (to cover additional forms and work for CPA)
Example: Incorporating in California– $100 to file (form the entity)
– $25 to maintain (annual maintenance)
– $800 annual corporate tax (filed by accountant annually)
– $600 or more – CPA fees to file on behalf of your corporation
Regardless of where you file to incorporate, there are annual fees between $400 and $900, not including your CPA fees to file on behalf of the business.
Using an attorney to file for incorporation could cost between $1,000 and $1,500 and could also increase the annual filing and maintenance fees by approximately $300.
These costs can be significant if your business is only making $20K-$30K annually.
Consider your annual revenue, your personal assets, insurance coverage, and your long-term goals when determining whether incorporating is right for you and your business.
LIMITED LIABILITY CORPORATION (LLC)
A limited liability corporation, or LLC, creates protection by setting a financial liability that is limited to a fixed sum, such as the value of the owner’s investment in the business.
Small partnerships and solo business ventures are the typical types of businesses that create an LLC.
This includes businesses that intend to have passive shareholders or plan on seeking investors.
Incorporating provides a means for expansion when selling shares and accepting investors.
An LLC provides the corporation a shield and limited liability along with the ability to operate within
a partnership format, which carries less structure than an established corporation, such as:
- Annual meetings are not required
- Partners with shared control are permissible
In a traditional corporation, partners must determine who is appointed to an office, such as president or vice president, etc. And, if there are more than two partners in a traditional corporation, two could potentially rule to remove another partner.
With an LLC, it is permissible to have two or more partners share control and be active members of the business.
LLC OPERATING AGREEMENT
With an LLC, you will also be required to complete and file an LLC operating agreement, which is a statement of how the LLC will operate. There are free templates online that can serve as a guide to prepare you for meeting with an attorney to create this document, and there are also self-service options to help you create legal documentation such as the LLC operating agreement.
As a new business owner, determine which option is best for you and your business.
BUSINESS STRUCTURE
SOLE OWNERSHIP – DISREGARDED ENTITY
Because so many new businesses with a single owner have opted for an LLC, the IRS has created a special category known as disregarded entity and has created special provisions, such as making it unnecessary to file a corporate or partnership return — it just requires filing with a 1040 Schedule C. Always check with a tax advisor to determine your recommended filing status and forms.
CORPORATION
If you are planning to sell stock in order to raise money for your business, then it is possible that a corporation would be more appropriate, even if you are not starting out with shareholders.
The corporate entity allows the company to issue stock to its owners. Then the company hires management to operate the business on behalf of the shareholders.
Corporations consist of:
– Shareholders
– stock owners
– Board of directors
– decide and hire management and appoint officers
– Management
– runs the day-to-day operations of the business
There are mandatory meetings and a voting process for certain roles and issues. Since the traditional corporation has a set of operational components related to management and shareholders, it is generally not the right type of organization for a sole proprietorship; however, it is still an option.
A sole proprietor can be the board of director(s), hire management, be the sole shareowner, and hold annual meetings for yourself: one shareholder, one director, and one owner.
It is required that you follow all documentation such as bylaws, voting, and meetings.
These requirements are the activities that need to take place to maintain the financial responsibility shield. If any of the covenants are broken, so is the shield.
If setting up a corporation sounds like the right structure for your business, consult additional documentation, an attorney, or other self-serve resources before making a final decision – in particular, if you are planning on selling stock, refer to an attorney.
CLOSE CORPORATION (C CORP AND S CORP)
Another option to consider is a close corporation, which allows you to operate with a small group of people and without several of the formalities that accompany a traditional corporate structure. Some small businesses find benefit by having a small group of shareholders while still having the flexibility to operate like a partnership.
When it comes to filing federal taxes, there are differences between a C Corp and an S Corp, and the designation must be recorded. With an S Corp, the business income is reported on the shareholders’ personal tax returns and some small businesses may find this advantageous. Again, it is important to check with a tax advisor and if you have legal counsel, consult with them as well before making these designations.
Eligibility varies at the state level and some states do not recognize the classification of close corporation. There are several requirements for maintaining this status, so it is best to seek legal counsel to determine whether it is appropriate to set up a close corporation when starting your business.
OTHER LEGAL ENTITIES
While researching options other than those typically sought after, consider there are also:
- Limited partnerships
- Limited liability partnerships (LLPs)
- typically reserved for attorneys and accountants
- Limited liability limited partnerships (LLLPs)
- Public benefit corporations – such as churches and schools
- Nonprofit corporations
- fundraising and philanthropic– Co-ops – e.g., HOAs– Associations
- unincorporated
- Partnership