6.01 – Introducing the Legal Business Classifications
Choosing the legal structure for your business is a crucial decision that impacts your operations, taxes, and personal liability. With changing laws, entrepreneurs have more options than ever before. Your need for capital and protection from liability are just two reasons why understanding the available options is essential. Consulting with a qualified attorney or certified public accountant (CPA) can ensure you make the best choice for your specific situation.
This lesson provides a comprehensive overview of the different legal business classifications, helping you understand the factors to consider before making your decision.
Legal Business Classifications
Businesses typically fall into one of four broad legal classifications:
- Sole Proprietorship
- Partnership
- Corporation
- Limited Liability Company (LLC)
Many entrepreneurs assume that the best entity is one that lets profits pass through to the owners at their personal tax rate and that incorporating in their home state is always best. However, these assumptions can be incorrect depending on the specific circumstances of the business.
For instance, if planning an IPO (initial public offering) within two years, forming a C Corporation is advisable, as it is required for going public. Venture capital-backed businesses might also prefer a C Corporation and may choose to incorporate in states like California or Delaware due to their extensive corporate governance laws. Choosing the wrong entity can result in costly delays and lost opportunities, particularly for fast-moving sectors like tech startups.
Understanding the various factors that influence your choice of legal structure is crucial. Here are some key questions to ask yourself:
Who will be the owners of the company?
If more than one individual owns the company, a sole proprietorship is not an option. A C Corporation might be preferable for businesses with many owners due to its unlimited life and free transferability of interests. C Corporations also facilitate pension and stock option plans for numerous employees.
What level of liability protection do you require for your personal assets?
Different structures offer varying levels of liability protection. It’s essential to consult with an attorney and accountant and consider the advice of an insurance broker to ensure adequate protection.
How do you expect to distribute the company’s earnings?
Entities like partnerships, S Corporations, or LLCs allow pass-through income and losses, meaning tax items are allocated immediately without additional taxation, regardless of cash distribution. In contrast, C Corporations only allow salary or other forms of compensation to be paid out pretax from the company to an owner.
What are the operating requirements and costs of running the business under each form?
Manufacturing companies with significant machinery have different liabilities compared to service companies.
What are your financing plans?
Consider how attractive the form is to potential investors and whether you can offer ownership interests. Venture capital-backed companies typically require a corporate form, as many venture capitalists raise funds from tax-exempt entities that cannot invest in companies with pass-through tax benefits.
What will be the effect on the company’s and your personal tax strategy?
This includes minimizing tax liability, converting ordinary income to capital gain, avoiding multiple taxation, and maximizing the benefits of startup losses.
Do you expect the company to generate a profit or loss initially?
If you anticipate losses in the first few years, a pass-through entity can be beneficial as you can deduct losses on your personal tax return.
