Selecting a Legal Structure for Your Business

One of your first decisions in setting up a business is the legal structure. The options range from a sole proprietorship, which is usually operated by a single person, to a full-fledged corporation that is flexible enough to employ hundreds of thousands of people and generate billions of dollars in revenue.

Each of these types of business entity differs as to where liability resides, the type and rate of taxation and the amount of formal reporting to state and federal governments, among other things.

Your choice will depend on the kind of business you are or will be starting and your vision for the business’s future. If, for example, you are a freelance graphic designer who works alone from home with no plans to expand, the simplicity of a sole proprietorship might be just what you are looking for. As a business becomes more complex—with many employees, a more specialized management team, perhaps with facilities such as a manufacturing plant or warehouse—a more formal corporate structure would be necessary.

This section discusses the major types of business structure:

  • sole proprietorship
  • partnership
  • C corporation
  • S corporation
  • limited liability company (LLC)

TIP: The U.S. Small Business Administration has a wizard to help you in “Choosing a Business Structure.” A series of short questions will help narrow your options. See

Sole Proprietorship

The simplest and most common form of business entity is the sole proprietorship. It is the easiest to set up, as there are no outside owners or investors. Unlike a corporate structure, there is no requirement for corporate officers or a board of directors, and there is less paperwork.

The business is run by an individual, although it may use a trade name. A sole proprietor can hire employees. In fact, one of the employees could be the proprietor’s husband or wife.

There are no outside owners or investors. There is no potential to expand through bringing in additional owners or their capital.

A drawback to a sole proprietorship is that the owner is personally liable for every activity and all debt incurred by the business.

Another possible concern is that if the owner is ill, disabled or dies, the business is not structured for a backup manager to keep the business running. A sole proprietorship ends when the owner dies, so there may be complications with estate planning.

Tax Aspects of a Sole Proprietorship

A sole proprietorship structure avoids the potential for double taxation that may occur with a corporation.

Taxes are paid on an individual’s 1040, Schedule C (Profit or Loss from a Business, Sole Proprietorship) and Schedule F if farming is involved. As a sole proprietor, the IRS does not consider you an employee, and you must pay the full amount of Social Security and Medicare taxes, currently 15.3 percent, which is calculated on Schedule SE.

An important difference between a corporation and a nonincorporated business is the tax treatment of medical expenses for the owner and his or her family. A sole proprietor can deduct 40 percent of health insurance premiums on Form 1040. The remaining 60 percent of the premiums and other uncovered medical expenses are deductible only if they are more than 7.5 percent of adjusted gross income. A corporation can pay for all insurance premiums and uncovered medical expenses and deduct the costs as a business deduction.

What can I do about retirement plans?

A nonincorporated business can take advantage of several tax-sheltered retirement programs.

A Keogh plan permits a sole proprietor to put aside 25 percent of after-tax income, up to $30,000 per year. Under a Keogh plan, employees must be covered at the same percentage rate, and the employer makes the contribution. Deferred vesting is allowed, so employees can be required to work up to 3 years before they are covered.

What other retirement possibilities are there for a non-incorporated business?

Another option is a Savings Incentive Match Plan for Employees (SIMPLE plan). As an individual, the sole proprietor can also participate in a traditional Individual Retirement Account or a Roth IRA.


When two or more people agree to maintain a business for profit, it is considered to be a partnership. A partner may contribute money, expertise, time or energy to help the business grow and expects to receive a share of the profits in return. The potential for business success may be increased if each partner brings a unique set of capabilities that are complementary.

A partnership is similar to a sole proprietorship, but it allows more than one person to share in the ownership of the business. There is no legal separation between the business and the owners, and as with a sole proprietorship, there is less paperwork than there would be with a corporation.

Since a partnership does not file papers with the state as with a corporation, does that mean there is no paperwork?

You still need to get all required permits and licenses from the federal, state and local governments. You might need to register the business’s name with your state. (It may be called an Assumed Name Certificate.) If you are hiring employees, you will need an employer identification number (EIN) from the Internal Revenue Service, and you may need to register as an employer with your state.

Do we really need a partnership agreement?

Although a partnership is simple to form, many business advisors believe it is one of the most difficult to keep going. There is no legal requirement, but experts recommend that a formal partnership agreement or contract be completed. The contract should define the duties and responsibilities of each partner, how much time each partner will devote to the business and how profits will be divided. The amount and kind of capital contributed by each participant should be recorded.

A partnership agreement should also deal with how the partnership may be split up—the process for one partner being bought out by the remaining partner or partners or division of assets if the business is later dissolved for any reason. An enterprise should not be started unless everyone is optimistic that it will succeed, but it is to each partner’s advantage to anticipate a change in ownership or time devoted to the business.

What else should be in a partnership agreement?

You might want to include how to handle profit-sharing; it would be assumed to be an equal split unless otherwise specified. You can also agree to the process for removing or adding a partner so that the partnership does not get dissolved. A method for appraising the assets of the partnership should be specified in the agreement.

Why should I consider the partnership form of business?

One of the primary reasons people choose to start their business as a partnership is that there is no initial governmental paperwork, so it is simple and straightforward. (Remember, however, partners need to have a clear understanding of what each will contribute to the business, and that understanding should be in the form of a written agreement.)

As partners need to raise capital for their business, they may be able to present a stronger case for loans or simply have a wider network to draw on for funding resources. Also, in order to attract high-quality employees, the firm can offer the opportunity to become a partner.

What are the problems with a partnership form?

The partnership form shares some of the drawbacks of the sole proprietorship as well as some additional shortcomings.

Liability is a significant issue. Each partner is liable for the actions of the other. For example, business debts incurred by one person become the responsibility of all partners. Decisions such as how to share profits, as well as differences on how to manage the business, can trigger disagreements.

A partnership does not have a perpetual life. It can end when a partner leaves, either voluntarily or through death or disability.

How do taxes work for a partnership?

Generally, tax treatment for a partnership is similar to a sole proprietorship. Profits from the business are taxed at the partners’ personal tax rates, rather than the typically higher corporate tax rate.

Benefits such as health insurance cannot be deducted by the partnership, and they become part of the personal tax schedule of the partner.

What are the different types of partnerships?

Besides the general partnership that has just been described, there are two other types of partnerships.

Limited partnership

Like a general partnership, a limited partnership is made up of two or more people who agree to own and operate a business. The difference is that one or more of the partners does not manage the business and has limited liability. There must also be at least one general partner.

In addition to meeting the requirements of a general partnership, a written agreement is required and the words “Limited Partnership” must be included in the name. Your state will most likely require that you file a Certificate of Limited Partnership and keep certain records.

The partnership files an information return annually, but income or loss flows directly to the partners. Partners report their share of the profit or loss on their individual income tax returns.

Joint venture

A third type of partnership, the joint venture, is set up for a special purpose and has a limited time frame. A corporation can be the “person” in the partnership, and joint ventures can be combinations of large corporations as well as small businesses

C Corporation

A C corporation is a form of business that is completely separate from the owners and managers. It has a “life of its own.” A major advantage to a corporation is that, in most instances, individual owners (shareholders), directors and employees do not assume personal liability for its actions.

Some important features of a corporation include the following:

  • A corporation is state-chartered based on where its headquarters are located.
  • A corporation has a perpetual life and ceases to exist only when it is formally dissolved.
  • The corporation is owned by the shareholders, who elect the board of directors.
  • The board directs corporate strategies and policies. The board also elects the corporate officers (president, vice president, secretary and treasurer).

What does a “controlling interest” mean?

The percent of stock owned by a shareholder governs the amount of voting power he or she has. The vote of a shareholder who owns more than half the stock (51 percent) will be able to control the outcome of any ballot, so that shareholder is considered to have a controlling interest.

How many shareholders are needed to form a corporation?

Only one shareholder is required, and one person can comprise the board of directors and all corporate officers.

Forming a C Corporation

Forming a C corporation calls for meeting requirements set forth by your state. An Internet search under “[your state name] Secretary of State” should lead you to the forms you will need.

Steps that you will take to incorporate include:

  1. File the forms for your state’s articles of incorporation and pay the incorporation fee.
  2. Establish corporate bylaws and maintain a minute book to record board of directors’ meetings and the corporation’s annual meeting.
  3. Distribute stock certificates to shareholders.

Once you have incorporated, you will be required to hold an annual shareholder meeting, file an annual report with your secretary of state and pay any required annual fees.

What information will I need to file articles of incorporation?

The forms will ask you to list the business’s official corporate name and the purpose of the business, the name and address of the registered agent and details of share ownership.

How do I decide on a corporate name?

This is an important decision. To avoid potential legal problems, you must avoid choosing a name that duplicates or can be considered too close to a name used by an existing business. Your state will make sure that you do not duplicate a name that is registered with the state, but you may want to do a national search for an identical or nearly identical name, especially if you intend to do business outside of your state.

You will also want to make sure that the business name includes the words “corporation,” “company,” “incorporated,” “limited” or an abbreviation of those words.

What is a “registered agent”?

A registered agent is a person or entity who will receive tax and legal documents for the corporation. This can be a manager or shareholder of the company, or there are services that will handle the function for a fee. The registered agent must have a legal address within the state or jurisdiction that the registration covers. The corporation may be invalidated if the registered agent is not maintained.

What about raising capital for a corporation?

Like a proprietorship or partnership, a corporation can borrow money from a bank or other lender. But it can also raise funds by selling stock to shareholders. This money becomes a permanent part of the company’s resources and does not have to be repaid as a loan does.

Ongoing Legal Requirements for a Corporation

One of the continuing duties of a corporation is to maintain business and accounting records. It will need to keep the following at its home office:

  • articles of incorporation and bylaws and any amendments that are up-to-date;
  • any resolutions adopted by the board;
  • copies of written messages to shareholders, including financial statements that are required for shareholders;
  • names and addresses of directors and officers; and
  • the annual report most recently filed with the secretary of state.

Tax Aspects of a C Corporation

One of the drawbacks to the owners of a C corporation is the potential for income to be taxed twice—first as a corporation and second as a shareholder.

This can happen because the C corporation files its own tax returns as a stand-alone entity and pays any taxes that are due. The corporation then pays after-tax profits to shareholders in the form of dividends, and the shareholders will most likely have to pay personal income tax on the dividend money.

Is there any way to avoid double taxation?

If the shareholder is also an employee, the company can pay the shareholder-employee a salary, as long as it is considered a reasonable amount. The corporation can deduct the salary as a business expense so that it is taxed only once (as income by the employee).

Another option is to elect Subchapter S status if the business qualifies.

Shareholder Liability

As a shareholder, you are not liable for the debts and liabilities of a corporation. Generally, you are not risking your personal assets. You may, however, lose the amount of your investment if the corporation is not profitable or ceases to stay in business.

You may also be at risk if you personally guarantee a debt of the business. Also, if the corporation does not follow legal requirements or if corporate and personal funds are commingled, you might be liable.

Can directors be held liable for issues that relate to their service to the corporation?

Yes, directors, as well as corporate officers or employees, can be considered liable. This can be a problem in attracting directors or employees with the needed expertise. Companies can purchase insurance that will provide compensation for losses sustained due to actions of the directors and employees while they are performing their responsibilities to the corporation.

In addition, depending on the nature of the business, the corporation’s leaders must be sure that insurance is sufficient to protect the corporation from losses due to property damage or personal injury.

What if I want to close my corporation?

You need to gain shareholder approval and file a notice with the secretary of state. After taxes and other debts are paid, any remaining assets are distributed to shareholders

Subchapter S Corporation

An S corporation has the same formal organization as a C corporation, but the income flows directly to the owners, who are taxed at their personal rate. Thus, the owners avoid the potential double taxation of a C corporation, yet they retain the advantage of limited liability.

Incorporating an S corporation includes the same procedures and filings as a C corporation. The owners must elect Subchapter S status with the IRS by filing Form 2553, Election by a Small Business Corporation, and they must meet certain criteria.

All of these criteria must be met in order to qualify as an S corporation:

  • domestic corporation: organized under the laws of the United States, a state or a territory;
  • shareholders: cannot be a nonresident alien; cannot be a partnership or a corporation and must meet additional similar measures;
  • number of shareholders: cannot be more than 75;
  • stock: can only be one class of common stock with no preferred stock; and
  • certain types of corporations: are not allowed, such as an insurance company or a domestic international sales corporation.

Can I convert a C corporation to an S corporation?

Yes, if certain of rules are followed:

  • All shareholders must agree to the election.
  • No more than 25 percent of the company’s gross receipts during the 3 prior years may be considered passive income (such as rent from a real estate investment).

Can I convert to a Subchapter S corporation whenever I choose?

Timing is important in becoming a Subchapter S corporation. If you want to convert from a C to an S corporation immediately after starting the business, you must file with the IRS within the first 2½ months of the company’s first taxable year. If you do not meet the deadline, your business will be taxed as a C corporation.

If your business has been ongoing for some time as a C corporation, you can still elect Subchapter S status if you file with the IRS during the 12 months before the tax year that you want the company’s status to change.

Tax Aspects of an S Corporation

Since an S corporation is treated like a partnership for tax purposes, each shareholder’s portion of the profit or loss is included on his or her federal and state tax returns. This means that profits from the S corporation are only taxed once at the individual’s personal tax rate. Shareholders are personally responsible for any related taxes and for estimated income taxes.

So profit and loss are allocated among shareholders just the way it is done for a partnership?

For an S corporation, profits and losses are allotted in the same proportion as the stock ownership. If someone owns 10 percent of the stock, their share of the profit or loss is 10 percent. This might differ from the allocation of a partnership, as a partnership agreement can specify a distribution of the profit or loss that might be different that the proportion of stock ownership.

Shareholder Liability

Other than its distinctive tax treatment, an S corporation has the same features as a C corporation. That is, beyond his or her investment in the business, a shareholder is not personally at risk for debts or other liabilities of the business.

Can I convert an S corporation back to a C corporation?

Yes, if the conditions for an S corporation are no longer being met.

Can an S corporation have ownership of a C corporation?

An S corporation can own 80 percent or more of a C corporation. It can also hold subsidiaries if it meets certain qualifications

Limited Liability Company

The Limited Liability Company is another hybrid form of organization, blending features of a corporation and a partnership. It has the limited liability advantage of a corporation and the tax advantage of a partnership. Although LLCs are a fairly recent form of business, they are now recognized by all states and the District of Columbia.

Owners of the LLC are called “members.” If there is no written operating agreement, each member is considered to be a “manager.” An operating agreement can identify specific members to be managers.

Forming a Limited Liability Company

As with a corporation, there are a series of steps to form an LLC:

  1. Apply to your Secretary of State for your company name. The name identifies the form of business by using the words “Limited Liability Company” or “LLC.”
  2. Plan and agree to an operating agreement.
  3. File articles of incorporation with your secretary of state, including the required filing fees.
  4. As with other incorporations, you will need a designated registered agent and office to be filed with your secretary of state.
  5. Be sure to obtain licenses and permits at the local, state and federal level and pay the necessary fees.

What other forms do I need to operate an LLC?

Each year, you will need to file an annual report with your secretary of state.

Tax Aspects of a Limited Liability Corporation

If an LLC is structured properly, it is taxed in the same way as a partnership or S corporation. That is, each member/owner is allocated a share of the profit or loss, which is included on his or her state and federal tax returns. For tax purposes, LLC members are generally considered to be self-employed. That means they are responsible for their own estimated income taxes and related taxes.

It is important to make sure that an LLC is structured properly, or it can be taxed like a C corporation.

Liability for LLC Members

Beyond a member’s investment in the business, he or she is not personally at risk for debts or other liabilities of the business. A member’s personal assets are not considered to be liable for the actions of the business, unless the member guarantees a debt of the business or acts in a way that opens opportunity for liability.

Dissolving or Closing an LLC

The LLC is considered to be perpetual unless certain events take place. The LLC would be dissolved if a time is specified or a triggering event takes place as specified in the articles of organization. Other events that would trigger dissolution are:

  • A member withdraws from the organization, and remaining members do not agree to continue the business. (This possibility can be anticipated and become part of the operating agreement.)
  • All members agree and give their written consent to dissolve.
  • A court order requires dissolution.

Small Business: Forms of Business Chart

Form of business Legal filings Taxation Structure Advantages Disadvantages
Sole proprietorship Required licenses and registrations Personal rates, filed using Schedule C on Form 1040 Business ceases when proprietor leaves the business Easy to set up Does not protect against personal liability
Partnership Assumed name filing, required licenses and registrations Profit shared by partners at personal tax rates Dissolves when a partner leaves Fairly easy to set up; partnership agreement recommended Does not protect against personal liability

Only partial deduction for health expenses
C corporation Annual reports

Board of directors meetings
Separate tax return, taxed as separate entity

Corporate tax rates

Dividends taxed to shareholders
Perpetual existence

More than one class of ownership are possible (e.g., common and preferred)
Can protect against personal liability of individual shareholders regarding claims against the business Corporate tax rate is higher than individual

Double taxation of dividends

Additional administrative costs
S corporation Similar to C corporation Taxed at individual rate, Form 1040, Schedule C, E, and SE

Form 1120S, Income Tax Return for S Corporation and Form 1120S K-1

Must close books at end of year
Similar to a C corporation except must meet certain requirements to be treated as an S corporation Eliminates double taxation of dividends Cannot deduct benefits such as health insurance for shareholders owning 2% or more of the company

Cannot own subsidiaries

Cannot retain earnings

Typically fiscal year must be a calendar

No more than 35 shareholders
LLCs Exempt from corporate filings in most states

Operating agreement required
Taxed at individual rate, Form 1040, Schedule C (need approval of IRS)

Usually more accounting flexibility than C or S corporations
Somewhat of a hybrid between an S corporation and a C corporation Taxed at personal rate

Limited liability as a corporation