Choosing the Right Legal Business Form for Your Business Plan

Key Takeaways:

• The selection of a business's legal form, also known as its legal business form, determines how the business will be structured, taxed, and operated.
• The main business types include sole proprietorships, partnerships, LLCs, and corporations, each with unique advantages and disadvantages.
• Legal business forms impact personal liability, tax responsibilities, governance, and management.
• The choice of entity is flexible and can be adjusted over time based on the evolving needs of the business.
• Entrepreneurs can consult attorneys via UpCounsel for personalized legal advice related to business formation and structuring.

The legal form of organization in business plan is used to decide how the organization will function, how roles will be arranged and assigned, and how relationships will work. These organizational steps should take place at the beginning of the business formation.

Starting a Business

The first step when beginning a business is to name the business. The name must be unique and not in use by another existing entity. The next step is to decide on the organization type your business will use. Each business entity has specific requirements on how they are run including how income is reported. The business types include:

• Sole proprietorship.
• Partnership.
• Limited Liability Company.
• Limited Liability Partnership.
• Corporation.
• S Corporation.
• Tax-exempt organization.

Each type has advantages and disadvantages that should be reviewed before making a final decision. However, the business type you choose isn't permanent. As the needs of your business change, the business entity type can be changed. Examples include:

• Changing a sole proprietorship to a partnership due to growth.
• Switching to a corporation to establish protection that comes with limited liability.

Limited Liability is attractive to business owners because it protects personal assets from any debts or obligations incurred by the corporation.

Understanding Legal Business Forms

Choosing the right legal business form is crucial for setting the foundation of your business. This decision impacts everything from your personal liability to how taxes will be managed. Each business entity offers unique benefits and drawbacks that should align with your goals and future growth plans. When considering the legal form of your business, think about the following factors:

• Liability Protection: Some forms, like corporations and LLCs, protect personal assets from business debts, while others, like sole proprietorships, do not.
• Tax Considerations: Different structures are taxed in different ways. For instance, LLCs and S corporations allow for pass-through taxation, meaning business income is only taxed at the individual level, while corporations face double taxation—once at the corporate level and again on dividends.
• Management and Control: How much control you want over decision-making is another factor. Sole proprietorships and partnerships often allow more flexibility in management, while corporations require formal governance structures like a board of directors.
• Funding and Investment: Corporations can raise capital through stock sales, while LLCs and partnerships may find it more challenging to attract investors without offering ownership.

As your business grows, you may need to re-evaluate your chosen structure. For example, you may begin as a sole proprietorship and later change to an LLC or corporation to take advantage of liability protection or to attract investors.

Business Type Requirements

A major component of selecting a business type is what is required to be legal and the tax implications.

• Sole proprietorships are owned by one person or a marriage. Their requirements include:
  • Applications to the state government are not required.
  • Dependent on the state, registering the business may be required with the state and/or country.
  • A business license may be required based on the type of business and state requirements.
  • The IRS views all business activity as personal. When filing, personal and business income are seen as the same thing.
  • A sole proprietorship is personally responsible for all aspects of the business. If the business is sold, it can impact any personal assets if you are found liable.
• Partnerships can be a limited or general partnership. Their requirements include:
  • In a general partnership, two or more sole proprietors are seen by the IRS as having equal responsibility.
  • Any profit and loss distribution is determined by the partnership agreement and is then passed to the individual partners.
  • Profit and loss distribution does not have to match the percentage of ownership.
  • The partnership is not subject to income or franchise tax.
• Limited partnerships have one or more general partners or one or more limited partners. Their requirements include:
  • The structure and tax implications are similar to a general partnership, but a limited partnership (silent partner) allows for ownership without the requirement of being actively involved in how the business is managed.
  • Business liabilities are limited to the amount invested by the partner.
  • Outside investors can be partners without taking on any liabilities.
• Limited Liability Companies (LLC) combine the positive aspects of a corporation with the positives of a sole proprietorship (limited liability, the sale of stock) and partnership (shared management decisions, profits.)
  • Personal liability protection is provided without having to meet the administrative and governance procedures.
  • The Articles of Organization determine the ownership percentages, distribution of profit and losses, and voting rights. In corporations, this is determined by stock ownership.
  • Most LLCs use the pass-through method of taxation. This means that taxes aren't paid by the LLC, but by at the personal tax level of the owners. The personal rate is lower than the corporate tax rate. When the LLC files taxes, no money is sent and an owners report is included to show the owners will pay the tax instead.
  • Based on the state, the LLC is subject to a franchise tax.
• Corporations are legal entities that are separate from those who own and/or formed the organization. Their requirements include:
  • A corporation can be formed as for-profit or nonprofit.
  • Corporations provide a shield from liabilities. This protection is only removed if the owners or board members have been found to be illegally running a corporation and have been breaking federal and/or state laws.
  • Corporations can sell stock in the business.
  • A Board of Directors is used to manage corporate policies and strategies. This is for both for-profit and nonprofit.
  • Corporations continue to exist even in the event of the owner's death, or if owners leave.

Taxation and Compliance for Each Business Form

The tax structure and compliance requirements vary significantly depending on your chosen legal business form. Below is an overview of how different business types are taxed and the compliance burdens associated with each:

• Sole Proprietorship:
  • Taxation: Income is taxed at the owner's personal tax rate. The business does not pay taxes separately.
  • Compliance: Minimal requirements; however, the owner must file taxes as an individual. Personal liability extends to business debts and obligations.
• Partnership:
  • Taxation: Income is passed through to the partners and taxed at their individual rates. A partnership agreement outlines how profits and losses are shared.
  • Compliance: Partnerships are not subject to federal income taxes, but certain states may impose a franchise tax. Partners must file an informational tax return (Form 1065).
• LLC (Limited Liability Company):
  • Taxation: Most LLCs are taxed as pass-through entities (income passes to the owners, who then pay taxes individually). However, an LLC can elect to be taxed as a corporation.
  • Compliance: LLCs must file Articles of Organization with the state. In some states, LLCs are subject to annual franchise taxes or fees.
• Corporation:
  • Taxation: Corporations are taxed as separate entities. They must file corporate tax returns, and shareholders pay taxes on dividends, which results in double taxation unless the corporation elects S-corp status.
  • Compliance: Corporations are required to hold annual shareholder meetings, maintain a board of directors, and file annual reports. They must also comply with rigorous tax filings and regulations.
• S Corporation:
  • Taxation: An S-corp is a tax status that allows profits to pass through to shareholders’ personal income, avoiding double taxation. However, only corporations can elect S-corp status.
  • Compliance: Similar to corporations, but S-corps must meet additional IRS eligibility requirements, including limits on the number of shareholders and the types of shareholders.

Each business structure offers distinct benefits and burdens, and the decision should be made with your long-term goals and risk tolerance in mind. For personalized advice, consulting an attorney or tax advisor is recommended.

Changing Your Legal Business Form

As businesses grow and evolve, their legal business form may need to change to accommodate new challenges or goals. Transitioning from one legal structure to another is a relatively common practice, and it can offer benefits like enhanced liability protection, tax advantages, or better opportunities for raising capital. Here are common scenarios where a business might change its structure:

• From Sole Proprietorship to LLC: As your business gains assets or takes on additional employees, the need for liability protection becomes more urgent. Switching to an LLC can shield personal assets and provide tax flexibility.
• From Partnership to Corporation: If your partnership wants to expand or raise capital by offering stock, converting to a corporation may be a strategic move. Corporations can issue shares, which attracts investors and allows for growth.
• From LLC to Corporation: If your business reaches a certain size or needs to raise significant capital, converting to a corporation can help by offering greater access to funding through equity offerings.

Changing your legal form of business can be complex, and the process typically involves filing paperwork with the state, altering tax elections, and updating contracts with partners or clients. Consulting an attorney can ensure you navigate this transition smoothly and in compliance with all relevant laws.

Frequently Asked Questions:

1. What is the most common legal business form for small businesses?
   The most common legal business form for small businesses is the LLC, as it provides liability protection while offering flexible taxation options.
2. How can I change my business's legal form?
   Changing your business's legal form typically involves filing forms with your state’s business registration office and making adjustments to your tax filings and contracts. Consulting with a legal professional is recommended.
3. What are the key differences between a sole proprietorship and a corporation?
   A sole proprietorship offers no personal liability protection and taxes income at the individual level. In contrast, a corporation offers liability protection but is taxed separately, often resulting in double taxation.
4. Do I need a lawyer to choose my business form?
   While it’s not required, consulting a lawyer can ensure you understand the implications of each legal business form and help you select the best option for your business goals.
5. What is pass-through taxation?
   Pass-through taxation means that business income is reported on the owners' personal tax returns, avoiding the business itself being taxed. This is common for LLCs and S-corporations.

If you need help with the legal form of organization in the business plan, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.