Many business owners start a new venture without considering the appropriate business structure. Choosing the right legal structure for your business is an important decision that can impact operations, decision-making, tax obligations, and liability.
An experienced business formation lawyer in New Jersey can review your business plans and financial resources to help you select the right structure for your new business. Some business structures that exist include, among others, sole proprietorships, Limited Liability Companies (LLCs), C corporations, S corporations, Limited Partnerships (LPs), Limited Liability Partnerships (LLPs), and Professional Corporations (PCs).
Each type of business structure has its unique advantages and disadvantages. The following sections will therefore examine the fundamental advantages and disadvantages of three primary business forms: the Limited Liability Company, the Corporation, and the Partnership.
Limited Liability Companies (LLCs)
An LLC is a popular and flexible business structure that combines the liability protection of a corporation with the tax benefits and simple formation process of a partnership.
Advantages of Limited Liability Companies (LLCs)
Limited Liability:
In an LLC, if the business faces legal action or incurs a debt, the personal finances and assets of the owners (members) are more protected, provided the entity is adequately capitalized, adheres to legal procedures, the owners do not commingle personal and business assets, and are not using the liability shield to commit fraud or injustice.
These factors are considered by courts when a business with liability protection is sued. In such cases where a court reaches through the liability shield of an LLC to reach the personal assets of the controlling members, the court is said to be piercing the corporate veil.
Flexible Tax Structure:
LLC members can choose a tax structure that is most beneficial based on the needs of their business. An LLC can choose to be taxed as a partnership or a corporation by filing the required forms with the IRS. By electing to be treated as a corporation for tax purposes, the income of the business itself is first taxed and then it is taxed at the individual level. In contrast, when members elect the business to be treated as a partnership, the income is said to pass through the entity and only the owner is taxed.
The pass-through structure of an LLC partnership is beneficial because it is simplified and avoids double taxation. Whereas the election of corporate status allows for strategic tax planning opportunities. Moreover, while a partnership LLC avoids double taxation, the owner must pay self-employment taxes.
Fewer Formalities And Compliance Requirements:
Forming an LLC requires less paperwork compared to a corporation. The law does not require LLCs to hold mandatory annual meetings or adhere to as stringent record-keeping requirements as corporations. Day-to-day LLC operations are overall more simple and cost-effective.
Still, there are legal requirements with regard to formation, operations, and ongoing compliance. Some of these include, but are not limited to, filing a certificate of organization with the Department of State, adopting an operating agreement (in some cases), keeping official records in accordance with the operating agreement, and filing annual Beneficial Ownership Information (BOI) reports with FinCen.
Disadvantages Of Limited Liability Companies (LLCs)
Tax Considerations and Raising Capital:
LLC members are subject to self-employment taxes on their profits if they elect partnership treatment, as they are considered both employees and employers. Furthermore, it can be harder for LLCs to raise capital, as they do not have the ability to issue stocks; this makes it harder to attract outside investors. However, while LLCs can create complex equity structures through their operating agreements, they issue ‘membership interests’ rather than ‘stock.’
Venture capital funds and other institutional investors are often more familiar and comfortable with the standardized structure of corporate stock, which can make raising capital from these sources more challenging for an LLC. Additionally, LLCs often require the consent of a majority or all of the members of the LLC, unlike corporations, which can sell stocks more easily.
Navigating LLC Regulations in Different States Can Be Complicated:
If your LLC operates in multiple states, careful planning and compliance are required to avoid legal issues. To operate in another state, your business must complete several requirements: register as a foreign LLC, check the availability of your name with the Department of State, appoint a registered agent, and obtain a certificate of good standing from your home state. It is important to note, LLC formation regulations and fees can vary from state to state.
Corporations
A corporation is a type of legal entity that is separate and distinct from its owners (shareholders). A corporation is an artificial person that is capable of owning property in its own name; entering into contracts; incurring debt and other liabilities; and suing and being sued.
Shareholders of a corporation are generally not liable for the debts and obligations of a corporation, and losses incurred are limited to the value of their investment stock in the company. Management of the entity is vested in the board of directors, which is elected by shareholders.
The board, in turn, appoints officers to manage the daily affairs of the company. For a business with more than one owner, forming a corporation can protect owners from the actions or misdeeds of other co-owners or management.
Advantages of Business Incorporation
Asset Protection:
Sole proprietorships and partnerships may face unlimited personal liability for business debts or litigation.
If you have to shut down business operations or are a defendant in a lawsuit against your business, your home, vehicles, savings, and retirement benefits may be at risk. In a corporation, generally, owners are liable only up to their investment in the business, which provides a significant level of asset protection compared to sole proprietorships and partnerships.
Perpetual Existence:
Corporations have a separate legal existence distinct from their owners that is recognized by the state. If an individual owner, shareholder, director, or officer dies or leaves, the corporation can continue to exist and carry on business as usual.
Disadvantages of Business Incorporation
Extensive Paperwork:
Incorporating a business requires extensive paperwork, including corporate bylaws and Articles of Incorporation, which can take weeks or even months to complete.
Strict Compliance:
Businesses have to adhere to strict legal requirements and comply with state laws and regulations to maintain their corporate status.
Most corporations, C corporations in particular, face double taxation. Income from business may be taxed at the entity level as well as the shareholder level. However, if the owners of a business elect to form as an S-corporation, they can avoid being taxed at the entity level, and instead are only taxed personally on any income they earn from the S corporation.
In order to be considered an S corporation, the business must comply with certain regulations. Failure to do so might mean that your entity is treated as a c corporation for tax purposes.
Less Cost-Effective Compared to Other Business Structure:
Incorporating and running a business is a costly proposition. Paying filing charges, ongoing fees, and substantial taxes can take a severe toll on the financial health of the corporation.
Raising capital by selling shares is easier for established corporations, while newer businesses may struggle to attract investments. Newer businesses might find it difficult to attract investments.
Partnerships
A partnership is a business arrangement in which two or more individuals share ownership. The two main types of partnerships are general partnerships and limited partnerships.
- In a general partnership, all partners can act on behalf of the business and share equal responsibility for managing the day-to-day affairs of the business. Partners typically make decisions jointly and are personally liable for the debts of the business.
- In a limited partnership, there are general partners and limited partners. Limited partners are often investors who do not participate in managing day-to-day operations and have limited liability. The primary advantage for limited partners is that their liability is restricted to the amount of their capital investment.
Advantages Of Partnerships
Simplicity:
Partnerships are relatively easy to form with fewer legal and regulatory requirements. Partnership agreements can outline the terms of the business relationships between partners, such as decision-making rights, profit sharing, and resolution of disputes among partners.
A comprehensive partnership agreement is the most critical document for the business’s success and stability. This legally binding contract should be professionally drafted to govern the internal relationship between the partners.
Pass-through Taxation:
Partnerships can file an informational report (Form 1065) but do not have to pay taxes at the partnership level. Partners can benefit from pass-through taxation by reporting profits and losses on their personal tax returns.
Shared Vision And Expertise:
Partnerships allow like-minded individuals to pool unique skills, perspectives, expertise, and resources, benefiting business growth. .
Disadvantages Of Partnerships
Instability and Uncertainty:
Partnerships can dissolve if a partner passes away or decides to leave, unless otherwise specified in the partnership agreement.
Potential for Disputes:
Differences in business objectives, management styles, and opinions can lead to disputes among partners, which can disrupt daily operations and affect the future of the business.
Get Legal Guidance on Choosing the Best Business Structure
Choosing a business structure depends on the unique needs and aspirations of your business. Omni Law P.C., will help you understand the advantages and disadvantages of each structure. Schedule a consultation by calling at (646) 970-1345 to decide which business structure aligns with your business objectives and growth plans.