Choosing the Best Legal Structure (Intro)

Your Startup — What Legal Structure Is Best?
Introduction to a Four-Part Tutorial

The Options to Choose From

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As the owner of a startup, one of your earliest decisions is how you will structure your business. Will you operate it as a sole proprietorship, with no legal umbrella? Or will you give it a formal legal structure? And if so, what structure will you choose?

You can elect any of several options for a legal structure. You can form a corporation, a limited liability company, or a partnership. And under the corporate option you have the further choice of two alternatives, one called a C-Corp, the other an S-Corp. They derive their names from the section of the IRS code which governs them.

Whether you opt for a sole proprietorship or one of these legal structures, your choice has significant implications. It will determine

  • how your business is taxed
  • how the profits of the company pass to you as an owner
  • how your personal income from the business is taxed
  • and the degree to which your personal assets are protected in the event that your business has a court settlement made against it.

The most common business structures are called pass-through entities by the IRS.Most of these business structures are known as "flow-through" or "pass-through" entities, because their net profits flow directly to the owner before they are taxed by the IRS. In other words, the entity itself does not pay income tax.

The sole exception is the C-Corp. All of its profits are taxed before the owners and investors receive any distribution of profits. Once its tax obligation is satisfied, the corporation can then distribute any remaining profit to its shareholders — i.e., its owners and investors — in the form of dividends. These dividends are then taxed as income for the shareholders.

The result is "double taxation"" on the share of profits that pass to shareholders. Because of this double taxation, most small startups are not well-served by choosing to be a C-Corp. But as we shall see, under some conditions a C-Corp brings unique advantages to a startup that make the double taxation an acceptable trade-off. Moreover, for very small businesses, the double taxation can be avoided by paying end-of-year bonuses to the owner-manager which effectively eliminate the company's profits and any dividend distribution.

On the following pages we provide a brief, non-technical introduction to the pros and cons of sole proprietorships, LLCs, C-Corps, S-Corps, and partnerships. No one structure is right for all small businesses. So take a few minutes to familiarize yourself with your various options and make an informed decision about the best legal structure for your business startup.