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The Lowdown on Business Legal Structures

Adapted from The Small Business Start-Up Kit

You probably already have a rough idea of the type of legal structure your business will take, whether you know it or not. That's because, in large part, the ownership structure that's right for your business -- a sole proprietorship, partnership, LLC or corporation -- depends on how many people will own the business and what type of services or products it will provide, things you've undoubtedly thought about quite a bit.

For instance, if you know that you will be the only owner, then a partnership is obviously not your thing. (A partnership by definition has more than one owner.) And if your business will engage in risky activities (for example, trading stocks or repairing roofs), you'll want not only to buy insurance, but also to consider forming an entity that provides personal liability protection (a corporation or a limited liability company), which can shield your personal assets from business debts and claims. If you plan to raise capital by selling stock to the public or want to give your employees stock options, then you should form a corporation.

In all states, the basic types of business structures are:

  • sole proprietorships
  • partnerships (general and limited)
  • limited liability companies (LLCs), and
  • corporations.

If you focus energy and money into getting your business off the ground as a sole proprietorship or a partnership, you can always incorporate or form an LLC later.

Sole Proprietorships

Sole proprietorships are one-owner businesses. Any business with two or more owners cannot, by definition, be a sole proprietorship. Technically, a sole proprietorship is simply a business that is owned by one person and that hasn't filed papers to become a corporation or an LLC. Sole proprietorships are easy to set up and to maintain -- so easy that many people own sole proprietorships and don't even know it!

For instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions or an independent contractor who isn't on an employer's regular payroll, you are automatically a sole proprietor. This is true whether or not you've registered your business with your city or obtained any licenses or permits. And it makes no difference whether you also have a regular day job. As long as you do for-profit work on your own (or sometimes with your spouse) and have not filed papers to become a corporation or a limited liability company, you are a sole proprietor.

Partnerships

Bring two or more entrepreneurs together into a business venture, stir gently and -- poof! -- you've got a partnership. By definition, a partnership is a business that has more than one owner and that has not filed papers with the state to become a corporation or an LLC (or a limited partnership or limited liability partnership).

General vs. Limited Partnerships
Usually, when you hear the term "partnership," it means a general partnership. General partners are personally liable for all business debts, and each individual partner can be sued for the full amount of any business debt. Another very important aspect of general partnerships is that any individual partner can bind the whole business to a contract or business deal -- in other words, each partner has "agency authority" for the partnership. There are also a couple of special kinds of partnerships, called limited partnerships and limited liability partnerships. They operate under very different rules and are relatively uncommon.

Limited Liability Companies (LLCs)

Like many business owners just starting out, you might find yourself in this common quandary: On one hand, having to cope with the risk of personal liability for business misfortunes scares you; on the other, you would rather not deal with the red tape of starting and operating a corporation. Fortunately for you and many other entrepreneurs, you can avoid these problems by taking advantage of a relatively new form of business called the limited liability company, commonly known as an LLC. LLCs combine the pass-through taxation of a sole proprietorship or partnership (taxes on business income are paid on each owner's individual income tax returns) with the same protection against personal liability that corporations offer.

Corporations

For many, the term "corporation" conjures up the image of a massive industrial empire more akin to a nation-state than a small business. In fact, a corporation doesn't have to be huge, and most aren't. Stripped to its essentials, a corporation is simply a specific legal structure that imposes certain legal and tax rules on its owners (also called shareholders). A corporation can be as large as IBM or, in many cases, as small as one person.

One fundamental legal characteristic of a corporation is that it's a separate legal entity from its owners. If you're familiar with sole proprietorships and partnerships, you'll recognize that this is a major difference between those unincorporated business types and corporations. Another important corporate feature is that shareholders are normally protected from personal liability for business debts. Finally, the corporation itself -- not just the shareholders -- is subject to income tax.

Choosing the Best Structure for Your Business

Although there are many differences among the various types of business organizations, most business owners choose an operating structure based on one legal issue: the personal liability of owners for business debts. While the issue of personal liability can have a huge impact on successful small businesses a few years down the road, business owners who are just starting out on a shoestring often care most about spending as little money as possible on the legal structure of their business. This is certainly an understandable approach: Far more new businesses die painful deaths because they don't control costs than because they lose costly lawsuits. In short, for many new small businesses, incorporating or organizing as an LLC is as unnecessary an expense as a swank downtown office or a gleaming chrome espresso machine in the lunchroom. That said, owners of any business that will engage in a high-risk activity, rack up large business debts or have a significant number of investors should always insist on limited personal liability, either with an LLC or a corporation.