Choosing and Filling a Legal Structure for Your Business
When starting a business, you can choose between creating a sole proprietorship, partnership, corporation, or LLC.
Before you choose a legal structure, you should consider the type of business you intend to run and your relationship with investors, partners, and other key members of your team. The major factors to consider in choosing a legal entity include:
- Your business’ potential risks and liabilities
- Income taxes and investment needs
- The formalities and expenses associated with each business structure
Choosing a legal structure can be very complicated, and we strongly recommended that you consult with a business attorney and tax professional before you register your business. If you don’t have an existing relationship with a business attorney or tax professional, your Indiana SBDC regional office can provide you with recommendations. In the following sections, we will discuss the different types of legal entities so you can be informed and make the most of your time with an attorney, a tax professional or your management team.
Sole Proprietorship or Sole Proprietor DBA
A sole proprietorship is a business structure with one owner. Because they’re relatively easy to set up and maintain, most small businesses are sole proprietorships. If you do not formally choose a legal structure, your business will default to a sole proprietorship because there is no paperwork to file other than additional schedules on your personal income tax returns. Sole proprietorships are registered with the county where your business is located.
If you plan to operate your sole proprietorship under a name that is not your personal name, then you must file for an assumed name DBA (“doing business as”) certificate with the County Clerk in the county where your business is located. Note that a DBA certificate only applies to doing business in the county where you registered and does not cover the entire state.
There is no legal separation between the business and the owner in a sole proprietorship. This means that you will have all responsibility for the liabilities and debts of the business. For instance, if the business cannot pay money owed to a vendor, that vendor may sue you individually. It also means that any income or losses of the business are accounted for on your personal tax return.
If you’re operating as a single owner, you should carefully weigh the pros and cons of a sole proprietorship and a single-member LLC.
Advantages:
- Easy and inexpensive to establish
- Profits are taxed once at the owner’s income tax rate
Disadvantages:
- Owner has unlimited personal liability for the business’ debts
- Ownership is limited to one person
Partnerships
Two types of partnerships exist: general partnerships and limited partnerships. You can register for both types of partnerships through INBiz.
A general partnership is similar to a sole proprietorship except that it has two or more owners. Like a sole proprietorship, it is easy to set up and maintain. You do not have to register a general partnership with the state unless you operate under a business name other than that of your partners. In that case, you only need to file a DBA certificate with the county where the business is located.
A limited partnership has one or more general partners and one or more limited partners. The general partners control and operate the business and are 100% liable for the business’s debts. The limited partners do not participate in the day-to-day operation of the business, and their personal liability is limited to their contribution to or investment in the partnership.
We also highly recommended that all partners work together to create a partnership agreement or operating agreement that addresses roles, responsibilities, and contingencies to avoid disagreement and conflict between the partners. You will need to produce this agreement for lenders when seeking financing. In a general partnership, the owners have unlimited liability for the debts of the business. This means that even though the partners share the profits, each partner is 100% responsible for any debts of the business.
Advantages:
- General partnerships are easy and inexpensive to establish
- Each partner’s share of the profits is only taxed once
- Allows for ownership by more than one individual
Disadvantages:
- General partners have unlimited personal liability for business debts
- The partnership is legally responsible for the business acts of each partner
- A general partner’s interest in the business can only be sold or transferred by consent of all partners
Corporations
A corporation is a separate legal entity with its own rights, privileges, and liabilities separate from its owners. Its owners, sometimes called shareholders, are not personally responsible for the debts of the business unless they personally guarantee those debts. A corporation usually has more than one shareholder, but it can be 100% owned by one person. A corporation’s governance structure has three layers:
- Shareholders who elect a board of directors.
- The board of directors that oversees major policies and decisions for the company and hires officers.
- Officers who run the company on a day-to-day basis.
The corporation’s bylaws establish the rights and obligations of directors and officers. Due to its three-tiered organizational structure and legally mandated formalities, a corporation may be more expensive and complex to establish than the other business structures.
A corporation is created by filing Articles of Incorporation through INBiz. Every other year, corporations must also file a business entity report and pay a fee to maintain active status through INBiz.
C and Subchapter S Corporations
By default, the IRS characterizes corporations as C corporations. A C corporation (the entity itself) pays taxes at special corporate tax rates on the profits it earns and retains. C corporations also distribute earnings to shareholders as dividends, and those shareholders pay taxes on this income. Therefore, many people say corporate earnings are subject to “double taxation,” once at the corporation level and once at the shareholder level.
However, qualified small corporations and LLCs can ask the IRS to treat them as a subchapter S corporation. Subchapter S entities do not pay taxes on the earnings of the business; instead, the income passes through to individual shareholders or members and gets reported on their personal income tax returns. This eliminates the corporate “double taxation” of C corporations.
To be eligible for subchapter S status, businesses must meet a series of requirements, including having 100 or fewer shareholders or members.
Advantages:
- Easier to raise capital through sale of stock
- Limited liability for business debts – shareholders only risk their investment
- Easy to transfer ownership
- Can elect Subchapter S status with the IRS
Disadvantages
- More expensive to set up and maintain than other entity types
- Corporate formalities are complex but must be strictly followed to maintain corporate status and limited liability of shareholders
- Closely regulated by both federal and state government
- Double taxation if not eligible or fail to elect. Subchapter S status with the IRS
Limited Liability Company (LLC)
In many ways, a limited liability company (LLC) combines the advantages offered by both partnerships and corporations. An LLC’s members, or owners of the business, have limited liability protection like shareholders in a corporation, but they also gain the simpler operation and pass-through tax characteristics of a partnership.
A single-member LLC is a limited liability company with a single owner, and LLCs refer to owners as members. Single-member LLCs are considered a separate legal entity because of how liabilities are treated. LLCs protect the owner’s personal assets from being seized to pay for business debts.
In Indiana, you register for an LLC through INBiz and LLCs are issued Articles of Organization by the Secretary of State once the filing fee is paid. In addition to the Articles of Organization, an LLC’s members should create and enter an operating agreement. This document establishes consistency and understanding about how the company:
- Makes decisions and structures its management hierarchy
- Assigns duties to members
- Requires contributions from members
- calculates profits and losses
- Limits its members’ liability and protects them
- Adds, terminates, or changes its membership
Advantages:
- Limited liability for business debts and claims
- Flexible tax options
- Easier to establish and maintain than a corporation
Disadvantages:
- More complex start-up requirements than partnerships or sole proprietorships
Professional Service Corporation (PC)
A professional service corporation (PC) is a corporation that practices certain licensed or “learned professions,” such as law, medicine, or architecture. All shareholders or members of a professional entity must be licensed professionals. For example, if a law firm is a PC, all its shareholders must be licensed attorneys.
To create a PC, you must file Articles of Incorporation with INBiz. The entity must pay a filing fee and annual fees to continue operation and must provide updated lists of licensed professional equity holders each year. Additional steps may be required to register a PC, so you should consult an attorney to make sure you follow the proper steps.
Do you still have questions about creating a business entity in Indiana?
- Your Indiana SBDC advisor can help you weigh to pros and cons of each entity type and walk you through the registration process.
