What is the Best Legal Structure for your Business?

Before making a sale or meeting any customer, you must set up your business’ legal structure. 

Before making a choice on the type of legal structure, business owners have to first consider their business needs and goals as well as understand the features of each business structure.

But what is a business legal structure and why is it necessary to have one set up at the start?

A business legal structure refers to the legal entity it is recognised by in its area of operation.

A business legal structure is the key factor that determines what activities the business can perform, such as raising capital, responsibilities and obligations, and how much tax to pay. 

In this blog, we will look at the 5 main types of business legal structures that you can set up.

In each type, we’ll look at what it is, how it works, your financial liability, and raising capital.

By the end of the blog, you will understand what is the best legal structure for your business.

Five Ways of Doing Business

Your business can take on many forms of legal structures. The 5 most common forms are:

• Sole Proprietorship
• Partnership
• Corporation
• Limited Liability Company (LLC)
• Nonprofit

Depending on your needs, each legal structure has significant advantages and disadvantages. 

Making this choice will depend on the goals of the business, the demands of investors, how much control you want, tax considerations, and how much liability you are willing to accept.

Now let’s look at each legal structure, explaining what it is, its positives as well as its negatives.

Sole Proprietorship: Explanation

A sole proprietorship is a business owned by one person and operated entirely for their profit.

This is also known as a sole trader or self-employed, depending on where you are in the world.

It’s the easiest legal structure to create, requiring little to no approval and paperwork to start.

In a sole proprietorship, you get to control the business. You can manage it or hire managers.

All profits and losses that are generated belong to you. In other words, you are the business.

Also, taxes for a sole proprietorship are relatively easy to file to your personal tax returns.

As a sole trader, you don’t have to worry about double taxation, excessive compensation, etc. 

An example of this would be someone like a tradesperson or any other self-employed person.

These people are the business; they work for themselves and get to keep all of the profit.

They may hire other people to work with them, but generally the team is relatively small.

Sole Proprietorship: Pros and Cons

In a sole proprietorship, you are liable for any debts of the business. Because the business and owner are the same, your personal assets are available to pay the depts of the business.

Vice versa your personal obligations may be satisfied or paid off by business assets if need be.

You can sell a sole proprietorship as a business or close up shop and sell its business assets.

However, fractional sales (such as equity) to allow new owners or investors are not allowed.

The business ends with the death of the owner, permanent disability, or prolonged absence.

The ability of a sole proprietorship to raise capital is limited. You can’t sell shares for example.

Generally these businesses get loans after fully covering them with their personal assets.

As you can see, there are some advantages yet quite a few disadvantages being a sole trader.

However, it’s common for businesses to start as sole proprietorships then convert to another.

Partnership: Explanation

A partnership is formed when 2 or more entities join together for a joint business purpose.

This does not just mean 2 people, it can be a person and a business, two businesses, etc.

Partnerships can be general or limited. No formal document is required to form a partnership.

However, for the sake of the partners, a written partnership agreement should be drafted.

This document would discuss matters such as division of profit or dissolution should need be.

Unless started otherwise, the law assumes that the partners share the control equally.

In limited partnerships, one partner controls the operations and the other is just an investor.

However, in a 50/50 split, what happens if the owners do not agree on something? Nothing.

Instead of a 50/50 ownership, a 3rd party has a small percentage of ownership to resolve ties. That person is only called upon during a disagreement so that the business can move forward.

Partnership: Pros and Cons

Partnerships have an easy tax structure. Income earned by a partnership goes to the partners.

Partners pay tax on their share of the profits but the partnership itself pays no tax on profits.

Experts advise against general partnership structures: liabilities are personal and unlimited.

Each partner is personally liable for the actions of the other partner. In a limited partnership, only the general partner is personally liable. The limited partner is limited to their investment.

Because a partnership is voluntary, you or the other partner can end the partnership any time.

This is why an agreement for dissolution is important: division of assets, ownership of IP, etc. 

A partnership is primarily dependant upon the assets of the partners to raise extra capital.

Adding investors requires converting from a general to a limited partnership: a new entity.

Lenders will look for a fully covered loan be to personally guaranteed by the partners.

Corporation: Explanation

A corporation is a legal entity created under the law. A corporation can manage its own affairs, hold and buy property, borrow money, and legally do anything an individual can do.

Stockholders may be, but not necessarily, employees, officers, or directors of the corporation.

An advantage of corporations is that they shield owners from liability.  If the corporation operates lawfully, then creditors can only have access to corporate assets for business debts.

This means that your personal assets are not at risk. The law requires the corporation to operate separately from the owner and to file all the required reports and taxes accordingly.

Sometimes a corporation fails to separate its corporate and personal assets. Failure to operate the corp adequately may result in a loss of protection from liability. If a creditor can show your corp hasn’t been properly operated they can access personal and corporate assets.

Corporation: Pros and Cons

Corporate protection from liability does not shield you from liability due to your own negligence. It also does not prevent the corporate owners and officers from being sued.  

Corporations have a 3 tiered system. Stockholders elect the directors of the corp. Then the directors elect the officers. Other than receiving dividends, stockholders have no other role.

The directors make primary decisions for the corp, and officers run the day to day operations.

Incorporating a business has many advantages. One of the most significant advantages is tremendous financial flexibility in raising capital. A corporation has the ability to provide you with the capital structure you need to accomplish your financial goals regarding investment.

However, not all businesses can be corporations depending on your industry and jurisdiction.

Talk to an attorney or accountant to see which corporation type is allowed and right for you.

Limited Liability Company (LLC): Explanation

A limited liability company is not a corporation or partnership. When structured well, it merges corporate liability protection with the tax and management flexibility of partnerships.

Because it’s the ‘newest’ form of legal structure, laws around LLCs differ from place to place.

You should speak with an attorney or accountant before adopting this form of legal structure.

To form an LLC, you must file ‘articles of organisation’ with the necessary governing body. 

You must detail how you will operate, share profits and losses, hire staff, and even fire them.  

The control of an LLC is in the hands of the owners (members) as in your operating agreement.

Members elect managers internally or externally, their roles, and the extent of their authority.

While the required amount of members varies from place to place, most require one member.

Usual day to day operations are run by managers, whereas members make all other decisions.

Limited Liability Company (LLC): Pros and Cons

One principle advantage of a limited liability company happens when it comes to tax time.

The LLC may be elected to be treated as a partnership. As such, the income and loss earned by the LLC is passed through the to the members and reported on their respective tax returns.

If no election is made, the LLC can be taxed as a sole proprietorship (the default for single member LLCs) or as a partnership (the default for multiple member LLCs).

Nonprofit: Explanation    

Believe it or not, some of the most profitable companies in the United States are nonprofits.

 Just up until a few years ago, the NFL with its billions of dollars in revenue, was a nonprofit!

The classification of ‘nonprofit’ does not mean that the business does not make a profit nor does it mean that it tried but failed to make a profit. It means that it has filed for and meets the requirements of a business that provides a service to the community for certain purposes.

These purposes may be religion, charity, science, public safety, literacy, education, hosting a national or international sports competition, or prevention of cruelty to children or animals.

Nonprofits aren’t allowed to distribute net income to owners, members, directors or officers.

In many situations, donations to nonprofits are tax deductible by the donor. However, it is best to have an attorney or accountant help determine what is and what is not deductible.

Nonprofit: Pros and Cons

Nonprofits are managed like corporations i.e. board of directors but they’ve no shareholders. A nonprofit does not pay income tax, but it does file ‘informational returns’. Just as with corporations, nonprofits offer protection from liability to its board, directors, and employees.

It’s not that easy to know whether your business concept will be eligible for nonprofit status. 

You should contact an attorney or accountant to learn more about nonprofit organisations.

Final Thoughts

The legal structure you choose will affect many aspects of your business including the extent and structure of your management team, controlling power, and how much profit you keep.

You may not be ready just yet to choose a legal structure for your business – and that’s ok! At least you will be more prepared when you come to consult with an accountant or attorney.

Just remember that you can always change from one legal structure to another down the line.

You may start off as a sole trader, and then change to an LLC as your business starts to grow.

Or if you think you’ll be a big company from the start, maybe you want to register as an LLC.

Whatever you choose, remember your choice is not final; you can change later if you want!

To learn more about legal structures, check out: Business Legal Structures: An Entrepreneur’s Handbook. It’s a great book that goes into business legal structures in much more detail!

Do you have experience with business legal structures? Please share in the comments below! 

If you have enjoyed reading, check out my other blog: What is your Business Exit Strategy?

Also if you have any suggestions for future blog topics, please share in the comments below!