The business landscape can be complex, with various laws and regulations governing each organizational structure. Understanding and choosing the proper one for your business is a critical decision that can significantly impact its success and longevity.
Should you establish a corporation or a limited liability company (LLC)? Read on.
The Role of a Business’ Legal Structure
The legal structure of your startup serves as the foundation on which all other aspects are built. It outlines the rights, obligations, and overall framework your company operates.
Let’s explore why choosing the right legal structure is vital.
Clarity of ownership and responsibilities
A well-defined legal structure provides clarity in terms of ownership and responsibilities among business owners. It reduces the likelihood of disputes and conflicts by clearly defining each owner’s roles, contributions, and decision-making authority. Establishing a clear structure minimizes disagreements that may hinder the progress of your business.
Business disputes can occur in various situations. But they are more common in small or closely held businesses. When individuals enter a business partnership, they may eventually disagree on managing the business or making important decisions about its future.
Since entrepreneurs usually invest significant time and money into the venture, these disputes can be highly contentious. They often involve legal claims related to breaches of contract, as well as complex matters concerning corporate governance and fiduciary duties.
This is supported by studies showing that businesses with well-established legal structures experience fewer ownership disputes.
Personal asset protection
No one starts a business thinking it will fail. However, it’s a reality that many small businesses don’t survive very long. The latest numbers show that only 34.6 percent of small businesses operate until they are a decade old. In fact, 20 percent close within the first year of operations.
As such, business owners must think about protecting their assets, whether its about data protection or literally protecting your venture through legal means. Registering as a sole proprietor means your personal assets are not legally separate from your business. If your new business faces financial or legal challenges, your assets could be at risk. Consider your personal liability protection by choosing a business structure, such as an LLP or a limited liability partnership. This type of business entity protects against business failure. Such a legal entity separates business debts from personal ones.
Maximize profitability
Different legal structures have varying tax implications, significantly impacting your business’s profitability. Understanding these implications is crucial for effective tax planning. Tax treatment differs, especially in different types of corporations.
For example, the IRS imposes corporate business taxes. By law, corporations must pay both direct and indirect taxes. Direct taxes are percentages of a company’s income. In contrast, indirect taxes cover various types, such as sales, value-added, excise, property, payroll, and import/export duties.
Furthermore, a form of business structured as an S corporation may benefit from significant income tax savings compared to a sole proprietorship or general partnership. It circumvents the disadvantage of double taxation faced by typical C corporations. S corps enable profits and certain losses to be directly distributed to owners’ personal income, completely bypassing corporate tax rates. This setup effectively minimizes the burden of corporate taxes on individual shareholders.
You must file your taxes under your personal tax return if you are a sole proprietor. You must also make payments towards the Social Security and Medicare systems, collectively known as “self-employed taxes.” This income tax return is comparable to the payroll tax that employees of a company contribute.
Promote investor confidence
Investors often seek clarity and accountability from specific legal structures like corporations. Businesses structured as a C-corp tend to attract more significant investments due to the transparent ownership and governance mechanisms in place. One survey found that 74 percent of venture capital firms choose companies to invest in by checking the business plan.
Adopting a structure that instills confidence in potential investors can open doors to additional funding and growth opportunities for your business. Getting business loans as a corporation is also easier than a startup under DBA (Doing Business As).
Ensure business longevity
The legal structure you select also impacts the continuity and longevity of your business. Sole proprietorships and partnerships lack perpetual existence. If the owner retires or dies, the company may cease to exist.
In contrast, corporations have perpetual existence, allowing for smoother succession planning and business continuity. The business’s type of legal structure also defines the company’s ownership transfer.
One research found that only 30 percent of family-owned businesses successfully transition to the second generation. Furthermore, only 12 percent survive to the third generation.
Choose Your Business Structure Wisely
Selecting the appropriate legal entity is a business decision that should not be taken lightly. It establishes clarity, protects personal assets, maximizes tax efficiency, attracts investors, and ensures business continuity. Understand the implications and seek professional guidance to arrive at an informed decision that aligns with your business goals and sets the stage for success.
Remember, the different types of business structures are unique. What works for your peers may not work for you. For example, a corporation must have articles of incorporation, a board of directors, and a business bank account. You have to make sure that you can comply with these legal requirements. Partnerships must have a partnership agreement, whereas an LLC must have an operating agreement.
Assess your business’s specific needs and consult legal and financial professionals to help you make the best choice for your business’s future.