How to Determine the Legal Structure of Your Business
A business entity usually referred to as a corporate legal structure, is a category of government that controls specific elements of your company.
Your tax burden is based on the legal structure of your business at the federal level, and it may have consequences for responsibility at the state level.
Due to the fact that every business structure operates with business legal issues differently, it has always been difficult to understand how legal structures work, how they affect corporate growth, and how to choose the right kind of corporation for your business.
The organisation’s objectives are impacted by the choice of company structure, which also impacts one’s capacity to acquire capital, the amount of paperwork that must be completed, and personal liability.
Making informed decisions might help you prevent future problems that are not essential and reduce your tax obligations as a result of regional or general constraints.
What is a Business Structure?
A company’s organisational status is formally represented by its business structure, and it specifies who owns a firm and how the enterprise divides its revenues.
Before registering your firm with the local, state, or federal governments, you’ll need to have a business structure in place. Choose wisely because it might be difficult and expensive to switch to a different business structure later.
How to Determine the Legal Structure of Your Business
Entrepreneurs across the world widely use four main types of business structures, which are:
Solo proprietorship
A particular kind of corporate entity where the owner and the company are the same in terms of the law. The sole proprietorship is the most typical legal structure for small firms.
Taxation: Pass-through taxation is available to a sole proprietorship, and the company does not submit a tax return. Instead, a Schedule C is used to declare the revenue (or loss) on the owner’s personal tax return.
Liability: The single proprietorship’s owner is entirely responsible for any obligations the company faces. Sound contracts and insurance can help you reduce this risk.
Formation: The simplest business structure is a sole proprietorship. A sole proprietorship may be formed for very little money with almost any paperwork.
Partnership
A partnership involves two or more company owners looking to make a profit. Although partnerships can be formed with minimum formality, it is advisable to draught a partnership agreement because there will be several parties. A partnership agreement details the conditions of the partnership by, among other things, formalising the rules for profit- and loss-sharing, ownership proportions, dissolution terms, and management rights.
General partnerships
The partners share equally in the ownership and management of the business as well as the risk of the company’s debts, other partners’ decisions, and financial commitments. The term “limited liability partnership (LLP)” is also used to describe this corporate organisation.
Limited partnerships
Both general and restricted partners can be a part of a limited partnership (LP). The general partners would have the same responsibilities and liabilities in a general partnership.
The limited partners, who are often investors, have little or no accountability and little or no authority over the firm. Personal tax returns include profit information.
Taxes: A partnership is an entity that reports taxes but does not pay taxes. A partnership is not required to pay federal income tax, but it must submit an annual information return (Form 1065) to the IRS to disclose earnings and losses from operations.
Based on the owners’ profit-sharing quotas specified in the Partnership Agreement, profits and losses are distributed to them. Taxes are paid by each partner on their portion of the profit or loss.
Liability: Owners are often personally liable indefinitely, and each partner is jointly responsible for the duties of the partnership.
Limited Liability Company (LLC)
It is anything in between a corporation, a general partnership, and a single proprietorship. Members of an LLC are its owners, and individuals, businesses, other LLCs, and international entities can all be members. Known as a “single member LLC,” an LLC with just one owner is legal in most states.
Taxation: For taxation reasons, an LLC is a “pass-through entity.” It implies that business income is distributed to LLC members through the LLC, who then record their respective gains or losses on their individual income tax returns. Similar to a general partnership, an LLC firm must submit an informative tax return.
Liability: Limited liability protects LLC members from personal responsibility for the debts and claims of the company. Only the business’s own assets are in danger if LLC is sued or has a debt. Except in circumstances of fraud or unlawful activity, creditors are not permitted to access the personal assets of LLC members.
LLC members should use prudence to avoid “piercing the corporate veil,” which might subject members to personal responsibility.
For instance, LLC owners should never conduct business using a personal checking account and should never address clients by their own names but rather by the LLC’s corporate name.
Corporations (C-Corp, S-Corp and B-Corp)
The most complicated type of company structure is a corporation. A corporation is a business owned or operated by shareholders but exists in law as a distinct, independent entity.
A company can enter into commitments independent of the owners, but it still has obligations, such as paying taxes.
In general, corporations are better suitable for larger, more established businesses with several workers or when other circumstances exist (i.e. corporation sells a product or offers a service that could expose the business to sizable liability).
Stock shares are issued to establish ownership. Corporations are the most complicated business structure and deal with many legal issues.
Corporations can get classified as— C-Corps or S-Corps. The two entities’ tax status is the primary distinction between the two types of corporations:
Taxation (C-Corp)
A C-Corp is a separate taxpaying entity for federal income tax purposes, and as such, the business files its own tax return. Any corporate earnings made by a c-corporation are subject to corporate income tax (entity pays taxes).
The shareholders must pay personal income tax on the corporate earnings that the business distributes to the owners. C-corps are thus liable to “double taxes.”
Taxation (S-corp)
For federal tax reasons, S-Corps can decide to pass through company income, losses, deductions, and credits to its shareholders. The entity must still record all income, losses, gains, deductions, credits, etc.
S company shareholders pay federal income tax at their tax rates and record the corporation’s profits and losses on their personal tax filings. S-Corps avoid double taxes as a result.
Liability: A company is a type of “immortal” entity, which means it does not end with the death of its stockholders. Since they are not personally responsible for the company’s debts and commitments, corporation shareholders have limited accountability.
A shareholder cannot suffer a loss greater than their initial investment in the company. Shareholders should be careful not to “lift the corporate veil,” similar to the provisions of an LLC.
The company name should always be used when speaking with clients, and personal checking accounts should never be utilised for commercial reasons.
Formation: Compared to sole proprietorships, partnerships, and LLCs, corporations require more legal and accounting documentation and have more intricate operational procedures.
A significant drawback of a corporation is the extensive governance and control provided by the board of directors. When several shareholders or investors are engaged, this frequently causes the decision-making process to get prolonged.
B corp
A benefit corporation, often known as a B corporation, is a for-profit corporation recognised by the majority of States. B corporations don’t differ from C corporations in terms of taxation but in terms of purpose, responsibility, and openness.
Both mission and profit motivate B corps, and shareholders want the corporation to provide social good and financial gain. Several states require B corporations to file yearly benefit reports that show how they improve society.
In states where the legal status is accessible, there are several third-party B corp certification services. However, none are necessary for a corporation to be considered a B corp.
Close corporation
Unlike B corps, close companies have a less conventional corporate structure, and these do away with many formalities that usually apply to corporations and smaller businesses.
Shares are typically prohibited from public trade; however, state regulations differ. A small number of owners can manage a close corporation without needing a board of directors.
Cooperative
A cooperative is a company or group run and owned by the people who use its services. The cooperative’s members, or user-owners, share in the profits and revenues the business makes.
The cooperative is often administered by an elected board of directors and officials, while regular members have voting rights to influence how the cooperative is conducted.
By acquiring shares, members can join the cooperative, but the number of shares they own has no bearing on how much influence they have over voting decisions.
Combine several organisational forms
S corp and nonprofit designations, for example, aren’t only company formations; they also have a tax status. An LLC may get taxed as a C corporation, an S corporation, or a nonprofit.
These agreements are far less frequent and may be trickier to put up. If you’re thinking of using one of these unusual structures, you should consult a business advisor or an attorney before making your choice.
Nonprofit
Nonprofit organisations fall on the other extreme of the business structure range.
They are a “not for profit” business structure, which means they don’t exist to make money for shareholders instead of investing it in a social mission, cause, or goal. For this clear reason, they differ significantly from the preceding business forms.
Who is a nonprofit for?
A nonprofit company is ideal for those whose goals are philanthropic, educational, scientific, religious, or literary—basically, for companies that are free from paying taxes.
This can include nonprofits that offer homeless shelters, environmental organisations, performing arts venues, museums, various educational institutions, and more.
Things to Consider When Selecting a Business Structure
While many of the above business models may be used to start a business, there are a few things to consider so that there are no business legal issues. The following are some things to consider:
Existence Continuity
Knowing the correct type of business structure is crucial if one hopes to protect the business for the future financial stability of the firm’s family members. It will help sustain the heritage of the company.
Complex Methods
Businesses with fewer employees overseeing their operations must choose a straightforward business structure.
To pick the best legal structure with the least amount of operational complexity, several processes and compliance standards must be followed when starting and running a firm.
Liabilities
By selecting a model with minimal liabilities, one may take risks without thinking about losing personal assets. Doing this will protect the company from any potential losses and debts.
Control
Deciding on how much control each person needs to function in a corporate organisation is also crucial. For instance: A sole proprietorship or a one-person corporation will be more appropriate for the person if they need greater control. Understanding the degree of control one wants over the company is crucial.
Financial Needs
The investment necessary for the efficient operation of the firm is one of the most crucial things to consider when selecting a business structure. Maintaining all needs with the company’s capabilities is vital for the firm to flourish.
Management
The entrepreneur should station individuals with relevant knowledge and potential to attain specific management tasks to ensure effective and efficient management of the enterprise’s activities.
Technical, conceptual, leadership, interpersonal, and other management skills are only a few of the numerous qualities that make up the category of management skills.
Individuals with strong managerial abilities enhance the long-term success and smooth operation of the business since they organise, inspire, and increase the teams’ productivity.
Government rules and regulations
In addition to being formally registered, business organisations may need certain licences and licences to function. Depending on the sort of business and its activities, a firm may need to get local, state, and federal licences.
To prevent legal repercussions, the company organisations must also adhere to all applicable rules, laws, and regulations.
A few main laws controlling business in India are the Income Tax Act of 1961, the Companies Act of 2013, the Foreign Exchange Management Act of 1999, and the Indian Contracts Act of 1872.
The Indian federal government has also started several initiatives to help new enterprises financially and promote entrepreneurship in India.
Why is a Business Legal Structure Important?
One of the important choices you can make is choosing the appropriate business structure from the beginning. These elements are crucial and aid in choosing the proper legal corporate structure.
Taxes
Business income for owners of sole proprietorships, partnerships, and S corporations is classified as personal income, and C corporation revenue is corporate income that is separate from an owner’s income.
Because the company and personal income are taxed at different rates, your chosen structure might significantly influence your tax liability.
Liability
In the case of a lawsuit, limited liability corporation (LLC) arrangements can shield your assets.
However, LLC formations are only recognised at the state level; the federal government does not recognise them. A government corporate form known as a C corporation offers LLCs liability protection.
Paperwork: There are specific tax forms for each legal type of firm. A corporate structure necessitates the submission of articles of incorporation and the ongoing filing of specific government reports.
Hierarchy
Corporations must have a board of directors, which must meet a predetermined number of times annually in some states. Corporate hierarchies also stop a firm from closing down when a founder passes away, an owner transfers shares, or the company quits. This closing protection is absent from other buildings.
Registration
To register your firm in your state, you must also have a valid business structure. Without a business structure, you cannot apply for an EIN-Employer Identification Number or all your required licences and permissions. Not doing a proper registration can lead to many business legal issues.
Fundraising
Your organisational structure may prohibit certain methods of money raising. For instance, sole proprietorships often aren’t permitted to market stocks, and businesses mostly hold that privilege.
Although you can modify your business structure in the future, your first structure choice is critical. However, altering your company’s structure can be a disjointed, perplexing procedure that might impact taxes and result in the accidental closure of your company.
No, matter what kind of legal structure you select, there are several advantages to incorporating your firm, including:
Conclusion
Overall, picking the right legal form for your company is crucial since it affects several financial issues. Therefore, carefully select the finest legal entity and consider the crucial elements of managing your firm.
Do not forget that you may embrace expansion and simplify operations throughout economic shifts once you have chosen your business structure and subsequently decide to modify it.
Determining whether or not personal liability protection is required will have a significant impact on the type of business structure you select.
Consult an attorney in start-up counselling would be most qualified to answer this issue and explain the risk and implications associated with each structure. Businesses that carry any degree of risk need liability protection.
