Deciding on a business structure can be one of the most challenging tasks you’ll have to undertake when starting a business.
One of the first decisions that lawyers have to when starting a firm is to choose their business structure – the legal entity you want your business to be known. It’s imperative to select the right one as it will affect how they operate their business, file their taxes, and determine their liabilities as to the owner or co-owner of a rising enterprise.
Choosing the best business legal structure can be overwhelming and confusing for business owners, even for some attorneys. If you are considering starting a new business it is crucial to understand the different business legal structures in the United States and go through the factors you need to consider when choosing the best one that suits your law firm’s needs and goals.
What are the most common business structures?
The most common business entities are sole proprietorship, partnerships, limited liability companies (LLCs), and corporations. Before diving into how you can choose the best business structure for your business, let’s have a quick run-down of what each business entity entails.
1. Sole proprietorship
A sole proprietorship is the simplest and most common type of business legal structure in the United States. In this type of business entity, only one person is in charge of the entire business. The same person is also personally liable for the company’s debts as this business entity doesn’t offer a separation of personal and business assets. If you’re running a newly established private law practice, then this one might be a viable choice for you.
Among the many benefits of a sole proprietorship is that it’s easy to set-up. The paperwork you’ll need is your business’ taxes, employer identification number (EIN), business registration, permits, and other licenses that prove your business’ legality. You become a sole proprietor by offering your expertise or legal service to the public. Sole proprietorships are also low-cost. The fees associated with the business entities are limited to licensing fees and taxes.
Tax-wise, sole proprietorships are considered as ‘pass-through’ businesses. This means that the attorneys can file their business taxes along with their taxable income. The law firm doesn’t pay its taxes separately.
A partnership forms when two or more people come together and decide to run a business. Perhaps, you and your roommate back in law school decide to open a law firm together. In this case, a partnership it’s better to form a partnership.
Partnerships are the most common business entity used by lawyers in their firms. It can be general or limited. In general partnerships, the owners share all aspects (profit, responsibilities) of the business equally. On the other hand, limited partnerships allow one person to have most of the company’s share, while the other owner(s) receives part of the profits.
It’s worth noting that in partnerships, the owners will be responsible for each other’s actions and decisions. Also, the lawyers’ personal assets would be at risk if the firm experiences financial trouble and becomes unable to pay for the business’s outstanding debts.
That said, if you’re forming a partnership with another lawyer, you might want to draft a partnership agreement together. Have a quick run-down of everything you’ve agreed on and ensure that it results in a win-win for both parties.
As for the tax perspective, the partnership owners must report profit and losses in their individual 1065 form. On top of that, the partners must pay a self-employment task based on the profit they get from the firm.
3. Limited liability companies (LLC)
Limited liability companies (LLC) are a relatively newer type of business entity that combines the benefits of a partnership and corporation.
The hybrid structure allows lawyers to choose between being taxed as a partnership (owner files the business’ taxes along with their personal taxable income statement) or corporation (owners file business and personal taxes as separate entities) and enjoy the personal asset protection like that of a corporation.
Furthermore, the banks can’t use the owner’s personal assets as payments should the company fail to repay its debts. Unlike corporations, LLC owners don’t have to form a board of directors. The company owners can meet and discuss the business matters whenever they like, just like a partnership. They will also have to pay a state filing fee, which could cost around $40 to $500, depending on what state you’re planning to operate in.
A law firm with a corporation as its legal structure is considered as a separate entity from its owners. In other words, there is a separation of the business and personal assets. This gives the owner(s) adequate protection for their assets if the company becomes unable to fulfill its financial obligations.
A corporation is composed of a large body of shareholders. Each of these shareholders owns a part of the company and can have a say in every business decision. Often, incorporated law firms go through double-taxation. This means that they will have to pay taxes twice – once as the company makes a profit and again when the company distributes its dividends to each individual owner.
Forming a corporation can be expensive, which is why the best companies that should consider it are those that are planning on the expansion (i.e., opening a law firm in another state, adding in more attorneys to work for the company). With corporations, it’s also easier to obtain funding. They can publicly sell their stocks to raise funds, which they can then put towards any business investments and opportunities.
Factors to consider before choosing a legal structure for your business
Now that you know the different business legal structures, you probably have an idea of what business entity you’re going to employ for your company. Before deciding, though, try to consider the following factors first:
Consider how much control you want to assume when setting up your business structure. If you’re going to have full control of the firm, a sole proprietorship would be a viable choice. On the other hand, if you plan on co-owning a business with another lawyer, whether friend or relative, a partnership would be a suitable choice.
In this case, you can agree whether you want your partnership to be a general one (equal distribution) or a limited partnership where one gets the majority of the share and control while the other owner(s) only receive a portion of it.
2. Personal asset protection
Next, consider how much asset protection you’ll need. Two of the business structures that offer personal asset protection are limited liability companies and corporations.
A corporation carries the least amount of risk as it’s entirely considered as a separate entity from its owners. In case the company incurs losses and cannot pay its debt, the owner(s) won’t be liable, and their personal assets can’t be used as payments.
LLC’s offer the same protection but with the tax benefits of a sole proprietorship. In partnerships, the owner(s) could agree on the level of liability each can assume. They should define it in their partnership agreement to ensure that it’s a win-win situation for each partner.
3. Funding access
All businesses need funding – even law firms. However, your company’s type of business structure can affect your ability to obtain financing from outside sources. Sole proprietorships may have a hard time getting funding from traditional lenders because of their unstable cash flow. The same goes for partnerships.
While they could still qualify and get approval for business loans, chances are, they won’t be granted favorable rates, unlike corporations with an established financial track record. In some cases, they may have to provide a personal guarantee or pledge personal assets to secure a business loan.
The most significant advantage of corporations is the ease of funding. They can easily sell their stocks to the public and raise funds for the company. Since they have a lot of business assets, they can also use them as collateral to take out a business loan from lenders.
Sole proprietorships, partnerships, and limited liability companies (LLC) are considered “pass-through” businesses. Owners will have to show the profit and losses the company incurred in their 1065 form and file their taxes along with their personal taxable income at the end of the year.
A corporation files and pays its tax separately at the end of every year. The company will have to pay for the taxes on profit after expenses. On top of that, the corporation’s owner(s) will have to pay their personal taxes (i.e., Social Security, Medicare) after they receive their share of profits from the company.
A sole proprietorship is the easiest and least expensive business structure to set up. Unlike other business structures, you won’t have to submit a list of documents to register your firm as a sole proprietorship. You simply become one by providing your legal expertise to the public and getting paid for it.
With partnerships, you’ll have to draft a partnership agreement that outlines each of the partners’ shares and responsibilities in the company. LLCs and corporations have to meet state and federal requirements like paying state fees and filing biennial statements (for LLCs) with the Department of State.
Deciding on a business structure can be one of the most challenging tasks you’ll have to undertake when starting a business. However, it’s necessary to choose the right structure as this has a direct impact on how your business runs. That said, here are some important questions to think about:
Are you running your business alone, or do you have other lawyers running it with you?
- Do you need ample protection for your personal assets?
- Do you want to be taxed separately?
Consider your long-term goals and decide on a structure around that. Once you’ve set up your business’s legal structure, it will then be easier and smoother to operate your law firm and set it up for success.