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Choosing the Right Legal Structure

by Kimberly Grob, special to CalCPA Online

Editor's note: This is the second of a four-part series on starting a small business. The other articles discuss creating a business plan, getting financing and dealing with taxes.

What does your business want to be when it grows up?

Once you've written a solid business plan that answers this question, you're ready to begin thinking about a legal structure for your new venture. "You need to know where your business is headed," says CPA Craig Malmgren, a tax manager at the firm of Lautze and Lautze in Oakland.

For instance: Do you plan to work alone? Do you plan to add employees over the next few years? Do you hope, some day, to be a corporation? And what will that corporation look like? Will it be small? Or large? Or somewhere in between?

But there's more. You'll also need to factor in tax, legal and compliance considerations. And to thoroughly examine these considerations, you'll need to seek professional help.

"Choosing a legal structure can be a complicated decision," says Malmgren. "And with the introduction of limited liability companies and limited liability partnerships, as well as major revisions in the S Corporation operating rules, the decision has become even more complex."

When attempting to sort through the various legal entities that your business can form under, the first step is to consult with your CPA, who can help you discuss options and plans for the future of your business. Depending on the complexity of the legal structures you're considering, your CPA will then refer you to an attorney. And if you're considering anything other than a sole proprietorship, Malmgren suggests that you spend the legal fees now in order to save time and money later. "An attorney can help you decide what the best entity would be for your scenario," he says. "And then they can help you with the legalities of setting it up."

A good attorney will weigh all the necessary factors to help you choose the best structure for your business. The type of business you're starting and the liabilities you'll assume, the distribution of the business' earnings, and your capital needs will all be important factors in choosing a structure. In addition, an attorney will weigh the legal restrictions and the tax advantages and disadvantages for your particular situation.

Know Your Structures
Most likely, your business' structure will fall into one of the following categories:

  • Sole Proprietorship: This is the easiest and least expensive structure. There will be some costs to obtain a business name registration and other licenses, but attorney's fees will be minimal because there are fewer documents to prepare than in a partnership, corporation or LLC. In a sole proprietorship, the owner has complete authority over all business decisions.
  • Partnership: Partnerships come in different forms. General partnerships result in no entity income tax and allow all partners to be involved in management decisions. Limited partnerships are more suitable for investors who want limited liability and are willing to give up the right to participate in management. But whatever type of partnership you form, it's important to remember this: Back it up with a legal agreement drawn by an attorney. The legal fees for forming a partnership will be higher than the fees you'll pay to establish a sole proprietorship, but they are usually less than the fees associated with incorporation. In a partnership, each partner is responsible for the other partner's actions as well as their own.
  • Corporation: This structure is more complex than the sole proprietorship and the partnership, and is usually more expensive to set up. Corporations can be incorporated in a number of ways, including the formation of C or S corporations. If your corporation meets eligibility requirements, it can avoid double taxation to the shareholders and to the corporation by electing to be treated as an S corporation. S corporations are generally exempt from federal tax. C Corporations are taxable entities. In a corporation, control of business decisions depends on stock ownership, and decisions are generally made by a board of directors.
  • LLC and LLP: Limited Liability Companies and Limited Liability Partnerships are not as expensive to set up as corporations, but they provide the benefit of limited liability. They are also easier to dissolve than corporations. For income tax purposes, LLCs and LLPs can be taxed either as corporations or partnerships. But unlike partnerships, they are subject to a progressive fee structure based on gross receipts. In LLCs and LLPs, the manager may have control of business decisions but all members are allowed to participate actively in the operation of the business.

Seek Professional Help
What's the best advice that CPAs and attorneys have for entrepreneurs weaving through this maze of legal structures? Don't go it alone. "When people are just starting a business, they are trying to save money wherever possible," says Malmgren. "But when it comes to setting up a legal structure, entrepreneurs shouldn't cut corners."

Instead, they should make educated, informed decisions that will help them to invest in their business' future. And with the guidance of a good team of tax and legal experts, you'll be certain to make the right decision about your business' legal structure -- a decision that'll save you money and headaches in the years to come.