Starting a business: What legal structure should you use?

Planning to start a business? Great. Should you start as a sole proprietorship or partnership? How about as a limited liability company or a C corporation? Choose the right answer and you’ll pay less tax, protect your personal assets from legal liability, and perhaps save money on accounting costs. Make the wrong choice and you’ll pay extra tax and put your home and personal assets at risk.

So, which legal structure is right for you?

The first choice is a sole proprietorship, which is an enterprise owned and operated by a single person. Under this legal structure, both the owner and the company are treated as being one and the same for tax and legal purposes.

The chief advantage of selecting to operate as a sole proprietorship is simplicity. Sole proprietorships are easy to set up—so easy, in fact, that many people own sole proprietorships without even knowing it. That’s because it is the default form: Every business with a single owner is automatically a sole proprietorship unless they take steps to select a different structure. This is true even if the business has never obtained licenses and permits or been registered with the appropriate authorities.

Consider an example. Say you have a day job but have a knack for snapping photos. A friend asks you to capture their wedding for a small fee, which you do without creating a name, forming a company, or getting a business license. Congratulations: You are a sole proprietor.

The downside to being a sole proprietor is liability. If the business cannot pay its debts, the owner is on the hook for them. If the business is sued, the owner is ultimately responsible. In short, the owner is personally liable for all of the business’ debts—he or she has unlimited liability. And, so, if a business is sued for enough money, the owner could lose virtually all of their personal possessions—their car, their savings, and perhaps even their home.

Scary, right? Not necessarily. It depends on the type of business you are running. Imagine your business. Now think about what would happen if everything went wrong with a client. Do they go to the hospital? Do they lose millions of dollars? Or do they just lose the money that they paid for your service? If a really bad day at the office includes clients getting sick, hurt, or losing heaps of cash, then unlimited liability can be a nightmare. But if you’re the previously mentioned photographer who would merely need to refund some money, then unlimited liability is hardly cause for losing sleep.

Now let’s take a peek at the sole proprietorship’s cousin: a partnership. At its simplest, it looks almost the same as a sole proprietorship, the main difference being that instead of one owner there are two or more owners. In other words, like a sole proprietorship, if a business has two or more owners but has yet to register and get licenses and permits, then the business is a partnership. Also, like a sole proprietorship, the business and each owner are treated as one and the same for tax and legal-liability purposes. Thus, a big enough lawsuit would risk almost all of the owners’ collective personal assets.

Fortunately, if you want to start a business but don’t want to risk all of your assets, you have options.

One choice is to form a corporation. Corporations enjoy limited liability, meaning that an owner will only lose what they invested, nothing more.

Another advantage of corporations is fundraising. If your company needs to raise money, it’s relatively simple to sell stock in the company.

But running a corporation comes with at least two drawbacks. First, a corporation is taxed twice—once on the income that the company generates and then again on the dividends that it transfers to the company’s shareholders. Second, corporations tend to be more complicated to set up and maintain than a sole proprietorship or a partnership. You will need to create corporate documents, appoint a board of directors, and follow various corporate formalities such as holding annual meetings and executing corporate resolutions.

That brings us to the last and most popular legal form: LLCs. This form is popular because it merges the best of sole proprietorships, partnerships, and corporations. LLCs are simple to form and require fewer corporate formalities, all while enjoying limited liability (like corporations) and being taxed just once (like sole proprietorships and partnerships). Plus, they have other tax benefits for serial entrepreneurs who own several LLCs.

Because of its many advantages, an LLC is usually the right choice for a new business. But as with all things legal, the specifics of your situation matter a great deal. Therefore, it’s generally a wise investment to consult with your attorney and accountant before you decide what structure to use.

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Jordan Sundell is a lawyer primarily practicing business and real-estate law. He formerly worked for the CNMI Supreme Court and Bridge Capital and is now general counsel for several real-estate companies, including Joint Marketing. His columns—focused mainly on real estate and small business—are published every other Tuesday.