Your LivePlan Small Business Plan – Ownership and Legal Structure

PART OF PROPOSITION 2: DEVELOP A PLAN

“Do I need to form an LLC?”

As a CPA, this is one of the most popular questions I receive when someone is just starting a small business. It is also the subject of this section of the Complete Guide to Creating a LivePlan.

Your LivePlan Small Business Plan - Ownership and Legal Structure

If you’ve already determined your business’s ownership and legal structure, this section should be pretty self-explanatory.  

Define who owns the business and what form of legal structure has been adopted.

However, if this still undetermined, this post provides a brief rundown of what you need to consider.

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Overview

When it comes to defining your ownership and legal structure, there are two main questions to consider:

  1. Will your business have more than one owner?
  2. Will you adopt a legal structure other than the default prescribed by the Internal Revenue Service?

TIP: It is important to keep in mind that adopting a different legal structure, such as an LLC, does not necessarily change how your business is taxed. A common misconception among new business owners is that forming an LLC will help save on taxes, which is untrue. Forming an LLC is much more about legal protection than it is about tax savings.

Read on for details on what should be considered related to ownership and adopting a legal structure.

Ownership

One Owner

In the simplest, most common form of business ownership and structure in the United States, the sole proprietorship, one person owns and operates the business.

If you are starting your business yourself, will be running it yourself and do not need investors, there is likely no need to take on outside partners.

You can keep it simple and own 100% of your business.

The decision that must be made, as it pertains to this section of your business plan, is whether you need to adopt a different legal structure for legal protection.

You can read more about that later in this post.

More Than One Owner

The reasons for needing to take on partners are varied.

For example, you may have come up with the business idea with someone else, may need other people with a complimentary set of skills to help you run the business, or may need outside, equity investors (read more about financing here).

The list of reasons for taking on partners could fill a book and your reasons will likely be unique.

Document who will own the business and then move on to the slightly more complex issue of how it will be legally structured.

Legal Structure

There are lots of options when it comes to deciding how to legally structure your business in America.

Here, I touch on the most popular forms.

Sole Proprietorship

Default for one business owner
  • One owner
  • Report income on personal tax return
  • Unlimited liability for business debts and legal obligations
  • Simplest form of business

General Partnership

Default for more than one owner
  • More than one owner
  • Report income on partnership tax return, which passes through to individual
  • Unlimited liability for business debts and legal obligations for all partners
  • Simplest form of partnership

Limited Partnership

Must file paperwork with state
  • More than one owner
  • Report income on partnership tax return, which passes through to individual
  • Unlimited liability for general, managing partners
  • Limited liability for limited, non-managing partners

Sole Proprietorship

If you are the only owner of your business, you are classified as a sole proprietorship by default for legal and tax purposes.

All income and expenses are reported on a Schedule C on your individual income tax return.

You bare all legal risk for decisions made in your business.

If something happens in your business that leads to legal action, your personal assets are at risk.

Legal protection is the main reason that you need to consider adopting a different form of legal structure.

If there is little to no legal risk involved in your business, operating as a sole proprietorship should suffice.

Partnership

If your business is owned by more than one person, you are classified as a general partnership by default for legal and tax purposes.

All income and expenses are reported on a separate partnership income tax return.

The purpose of a partnership tax return is to report and divide the income and expenses of the partnership based on the partnership agreement.

The partnership does not pay any income tax.

The profits or losses are distributed to each partner, which then get reported on the partners’ individual income tax return, where any income is taxed.

When you have partners, it is critical that you create a partnership agreement.

This can be as informal as a handshake or back of a napkin agreement on how profits and losses will be divided.

However, I strongly advise that you seek legal counsel to draft a partnership agreement.

You may be starting a business with a friend, family member, or someone else close to you and think an agreement is unnecessary.

But there a lots of reasons an agreement is important.

A standard partnership agreement doesn’t just define how profits and losses are distributed.

It will also lay out how much money each partner will contribute to the business, rules for admitting new partners, powers to borrow money, and the responsibilities of each partner, among other things.

You never know when having a formal agreement will be necessary, so if you are going to have partners you should make drafting an agreement a priority.

Attorney and CPA, Mark Kohler highlights partnership basics and why you may consider forming an LLC or S-Corp.

Legal protections afforded to you as a general partnership, the default classification, are similar to that of a sole proprietorship.

That is, there aren’t many.

Each partner in a general partnership is legally responsible for the debts and actions of the business.

Their personal assets are at risk if legal action is taken against the business, even if it is the result of something another partner or employee did.

You may consider creating a limited partnership to help remedy this issue.

In a limited partnership, each partner is classified as either a limited partner or a general partner.

Limited partners only risk the capital they contribute to the business.

General partners risk their personal assets.

At least one partner needs to be designated as a general partner in a limited partnership.

Typically, the general partner(s) is the one managing the business and limited partners are outside, passive investors.

Note: Whenever you are adopting a legal structure, especially when there are multiple partners involved, it is ideal to consult with an attorney.

In order to limit the legal exposure that exists for sole proprietorships, general partnerships, and limited partnerships, many small businesses elect to create an LLC or incorporate their business.

LLC

For flexibility and simplicity
  • Taxed just like a sole proprietorship or partnership
  •  
  • Limited liability for all members
  • Flexibility in allocating income and distributions
  • All income for active members subject to self employment tax

S Corp

For potential tax savings
  • Separate entity for tax purposes, though income passes through to shareholders
  •  
  • Limited liability for shareholders
  • Less flexibility in specially allocating income and distributions
  • Active shareholders paid a wage, potentially saving on self-employment tax

C Corp

For substantial growth
  • Separate, taxable entity
  •  
  • Limited liability for shareholders
  • Profits distributed as dividends also get taxed on shareholders’ individual return
  • No limit on number of shareholders

Limited Liability Company (LLC)

For small businesses that want to keep things relatively simple and flexible, but would like added legal protection, forming an LLC for their business is often the solution.

If you create an LLC for your business, by default, nothing changes in the way your business is taxed.

If you own 100% of the business, you are taxed just like you were a sole proprietorship.

In fact, the Internal Revenue Service labels you a disregarded entity for tax purposes.

If you are the only owner and don’t have employees, you do not need to set up payroll and accounting in your business should be relatively simple.

If your business has more than one owner, you will be taxed just as if you were a partnership for Federal tax purposes. Nothing changes here. And, again, if you have no employees, there is no need to set up payroll.

I mention payroll because, as you will read in my discussion on S-Corporations below, it is one of the differences between how an LLC and S-Corporation is taxed.

Note: In some situations, there can be some bigger picture and longer term tax benefits to creating an LLC. Additionally, some states tax LLCs as taxable entities. However, these topics are beyond the scope of this post. Just keep in mind that how your business is taxed Federally on an annual basis will not change just because you form an LLC.

The biggest benefit for small businesses forming an LLC is the additional legal protection it provides for debts and other legal obligations.

Attorney and CPA, Mark Kohler highlights the basics of the most common legal business structures in America.

Each state has its own rules when it comes to forming an LLC.

Therefore, if you have the resources, you should consult with an attorney.

However, in many cases you can form a single member LLC with limited assistance (reference this post).

The other popular legal structure for American small businesses is the S-Corporation.

S-Corporation

S-Corporations and LLCs are similar in many ways.

They offer similar legal protection for the business owner(s) and pass through profits and losses for Federal tax purposes.

The differences are in the details.

Some notable differences in how S-Corps are different from LLCs for tax purposes are:

  1. An S-Corp is always a separate entity for tax purposes and must file a separate tax return, even if you own 100% of the business. However, the S-Corp is not taxed at the Federal level or by most states, although some states do impose an entity level tax. The profits and losses are passed through just like on a Partnership return.
  2. If you manage the S-Corp, you will have to set up payroll and pay yourself a salary. In an LLC, owners are not paid a salary. Typically, all earnings from an LLC are subject to self-employment tax for active owners. S-Corporation owners only have to pay themselves a “reasonable” wage for the work they do, which is the only amount subject to self-employment tax.
  3. S-Corporations offer less flexibility in dividing profits and cash distributions than partnerships when there are multiple owners.
  4. Debt taken out in your business’s name has materially different tax ramifications depending on whether you are an LLC or S-Corporation.

This short-list really just scratches the surface.

For these reasons, and the fact that forming an S-Corp requires a few extra steps compared to forming an LLC, you should consult with a small business attorney or CPA if you want to develop a deeper understanding of the differences between these two legal forms of business and how each could impact your business.

The final popular form of legal structure is the C-Corporation.

C-Corporation

Forming a C-Corporation is a third option for small business owners looking to protect themselves from legal liability.

However, most small businesses elect to go with either the LLC or S-Corporation structure for tax reasons.

Unlike an LLC or S-Corporation, a C-Corporation is a taxable entity.

Profits are taxed on a C-Corporation’s income tax return.

Then, any profits that are distributed to the C-Corporations’ shareholders are taxed again on the shareholder’s tax return.

This is referred to as double taxation and is the biggest reason small businesses avoid the C-Corporation structure.

Of course, there are still reasons that some small businesses will elect the C-Corporation structure.

If you think that your small business could someday grow into a large, public company, adopting the C-Corp structure from the start may make sense.

Most public companies are C-Corps because the S-Corporation option has limits on the number and type of shareholders.

These limitations are not imposed on C-Corporations.

Again, this decision should not be made alone. Seek the assistance of an attorney or CPA for advice for your particular situation.

Next Steps

The decision on who will own your business and what form of legal structure you should adopt is unique to you.

Every situation requires its own analysis.

If you are starting small and own 100% of the business, operating as a sole proprietorship may suffice. You may even elect to create an LLC on your own in this situation.

However, as I’ve mentioned several times in this post, once you add partners to the situation or your legal exposure increases, you should seek out a professional for advice on your particular situation.

Document the decisions you have made regarding ownership and legal structure in this section of your plan.

I am not an attorney, but as a CPA for over a decade, I do have experience in the matters of legal structure.

You can access more of my insight on how various legal structures will impact you financially by signing up for the next LivePlan Online Workshop here.

Then, move on to documenting the Assembling of Your A-Team.

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