Starting a business involves many critical decisions, and one of the most important is selecting the right legal structure. Your choice can impact everything from your personal liability to how you pay taxes. Let's break down the key considerations to help you make an informed decision.
What is a Legal Entity?
A legal entity is a separate and distinct structure from you as an individual. This separation is crucial for two primary reasons:
Protecting your personal assets from business liabilities
Optimizing your tax planning strategy
Types of Business Ownership Structures
There are several legal structures to choose from, each with unique advantages and disadvantages:
1. Sole Proprietorship
Pros:
Easy and inexpensive to establish
Complete control over business decisions
Simple tax filing (profits reported on personal income tax)
No requirement for unemployment or workers' compensation insurance for yourself
Cons:
You are personally liable for all business debts
May not be able to get a separate bank account for your business (lenders prefer to work with an entity)
Limited options for adding additional owners
2. Partnership
Pros:
Easy to establish - in fact, it is the default form of entity when there are multiple owners
Partners are helpful:
Shared financial commitment
Ability to leverage diverse skill sets
Cons:
Potential for conflicts in decision-making
Partners are personally and jointly liable for business obligations
Each partner can bind the others to decisions [Note from Jen: These last two bullets mean that your partner can commit the company to an expense, and YOU are liable to pay it. In fact, you are *personally liable. Easiest way to avoid an accidental partnership? File to be an LLC.]
3. Limited Liability Company (LLC)
Pros:
Protects personal assets from business liabilities
Flexible ownership (can have one or multiple owners)
Tax flexibility (can choose how you want to be taxed)
Simple to manage compared to corporations
Cons:
Requires annual maintenance filings
Net income is subject to self-employment taxes
Must actually conduct business operations through the LLC to preserve liability shield
4. S Corporation
Under corporate law, an "S-Corp" is usually an LLC that has also filed an S-Corp election with the IRS.
Pros:
Separate entity status with liability protection
Tax advantages for small businesses
Limited employment tax liability
Potential for additional tax credits
Cons:
More complex operational requirements
Strict rules about compensation for working shareholders
Must comply with IRS regulations to maintain tax status
5. C Corporation
Pros:
Separate entity status with liability protection
Primary form for large businesses in the U.S.
Additional tax flexibility
Cons:
Most complex operational requirements, e.g. Board of Directors
"Double taxation": the Company files a tax return, and shareholders are also taxed on distributions/ dividends they receive
Other Structures to Know About
Limited Partnership: Combines active and passive investors; now mostly replaced by the LLC
Benefit Corporation (B Corp): Allows profit-seeking while considering societal benefits
Non-Profit (501(c)(3)): For organizations with charitable or educational missions (rather than making money for their founders). Requires filing with the IRS and ongoing reporting, in exchange for tax benefits. [Tip from Jen: Remember, you can do good work through an LLC. A lot of entrepreneurs have wonderful plans about giving back to their communities. No need to become a non-profit to do so.]
One More Optional Filing: Assumed Name/DBA ("doing business as")
Does not give liability shield by itself
Helpful in scenarios where you desire to use a quite different name as the public-facing name
My Usual Recommendations for Entrepreneurs:
Based on common scenarios, here are some practical steps:
Form an LLC as a flexible, protective business structure
If you have multiple partners, draft and sign a comprehensive Operating Agreement
If you are a service business with 1-2 owners, consult an accountant about potentially filing an S-Corp tax election
How to Form an LLC in Minnesota
I'm in Minnesota, where
it is easy to form a LLC. You'll need:
The desired name of the business
An address in Minnesota (not a P.O. Box) which will serve as its public address
Go to the Minnesota Secretary of State site. Create an account and pay the $155 filing fee
You'll get an email with a temporary link to download your Articles of Organization. Click through and save them somewhere - you'll need them to open a bank account, etc.
When to Form a Legal Entity
Filing to form your legal entity is a step that can wait during the process of planning your business. Generally, plan to file:
When you're committed to launching your business
Before signing significant contracts or leases
Especially if you have business partners
To establish a separate business bank account
Final Thoughts
Choosing a business structure is not a one-size-fits-all decision. Your choice depends on your specific business goals, potential risks, and long-term vision. Always consult with a professional accountant or business attorney to make the most informed decision for your unique situation.
Disclaimer: This guide provides general information and should not be considered legal or financial advice. Always consult with a qualified professional for personalized guidance.
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