7 Legal Structures of a Business You Should Know
Choosing the right legal structure for your business is one of the most important decisions you will make as an entrepreneur. The legal structure affects how you pay taxes, how you raise funds, how you protect your assets, and how you manage your business. In this article, we will explain the seven common legal structures of a business and their pros and cons.
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1. Sole Proprietorship
A sole proprietorship is the simplest and most common legal structure for a business. It is a business owned and operated by one person, who is responsible for all aspects of the business. A sole proprietorship does not require any formal registration or paperwork, and the owner can use their personal name or a trade name for the business.
The main advantage of a sole proprietorship is that it is easy and inexpensive to start and run. The owner has full control over the business and can make decisions quickly. The owner also keeps all the profits and pays taxes on their personal income tax return.
The main disadvantage of a sole proprietorship is that the owner has unlimited personal liability for the debts and obligations of the business. This means that if the business is sued or goes bankrupt, the owner’s personal assets, such as their home, car, or savings, can be seized to pay off the creditors. A sole proprietorship also has limited access to capital, as the owner cannot sell shares or issue bonds to raise funds.
A partnership is a legal structure where two or more people agree to share the ownership and operation of a business. There are two types of partnerships: general partnerships and limited partnerships.
A general partnership is similar to a sole proprietorship, except that there are multiple owners who share the profits, losses, and liabilities of the business. Each partner has equal rights and responsibilities in managing the business, unless they agree otherwise in a written partnership agreement. A general partnership does not require any formal registration or paperwork, but it is advisable to have a partnership agreement that outlines the terms and conditions of the partnership.
A limited partnership is a legal structure where there are two types of partners: general partners and limited partners. General partners have the same rights and responsibilities as in a general partnership, but they also have unlimited personal liability for the debts and obligations of the business. Limited partners are passive investors who contribute capital to the business, but they have no say in its management. Limited partners have limited liability, which means that they can only lose their investment in the business, but not their personal assets.
The main advantage of a partnership is that it allows for more flexibility and creativity in running the business. Partners can pool their skills, resources, and networks to achieve their goals. Partners also benefit from tax advantages, as they pay taxes on their share of the profits on their personal income tax return.
The main disadvantage of a partnership is that it involves shared risk and responsibility. Partners are jointly and severally liable for the debts and obligations of the business, which means that each partner can be held accountable for the actions of another partner. Partners may also have conflicts or disagreements over the management or direction of the business, which can affect its performance and reputation.
A corporation is a legal entity that is separate from its owners, who are called shareholders. A corporation has its own rights and obligations, such as entering into contracts, owning property, suing or being sued, and paying taxes. A corporation is created by filing articles of incorporation with the state government and paying a fee.
The main advantage of a corporation is that it provides limited liability protection to its shareholders. This means that shareholders are not personally liable for the debts and obligations of the corporation, unless they have personally guaranteed them or have acted fraudulently or illegally. Shareholders can only lose their investment in the corporation, but not their personal assets.
The main disadvantage of a corporation is that it is subject to more regulations and compliance requirements than other legal structures. A corporation has to follow state and federal laws governing corporations, such as holding annual meetings, keeping records, filing reports, and paying fees. A corporation also faces double taxation, as it pays taxes on its profits at the corporate level, and then shareholders pay taxes on their dividends at the individual level.
4. S Corporation
An S corporation is a special type of corporation that elects to be taxed as a pass-through entity by the Internal Revenue Service (IRS). This means that an S corporation does not pay taxes on its profits at the corporate level, but rather passes them through to its shareholders, who pay taxes on their share of the profits on their personal income tax return.
The main advantage of an S corporation is that it combines the benefits of a corporation and a partnership. An S corporation provides limited liability protection to its shareholders, while avoiding double taxation on its profits.
The main disadvantage of an S corporation is that it has more restrictions than a regular corporation. An S corporation can only have up to 100 shareholders, who must be U.S. citizens or residents, and who cannot be other corporations, partnerships, or trusts. An S corporation can only have one class of stock, and it cannot have more than 25% of its income from passive sources, such as interest, dividends, or royalties.
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5. Limited Liability Company (LLC)
A limited liability company (LLC) is a hybrid legal structure that combines the features of a corporation and a partnership. An LLC is created by filing articles of organization with the state government and paying a fee.
The main advantage of an LLC is that it offers flexibility and simplicity in running the business. An LLC can have any number of members, who can be individuals, corporations, partnerships, or trusts. An LLC can also choose how it wants to be taxed by the IRS, either as a pass-through entity like a partnership or an S corporation, or as a separate entity like a corporation. An LLC does not have to follow the same formalities and regulations as a corporation, such as holding meetings, keeping records, or filing reports.
The main disadvantage of an LLC is that it may not be recognized or treated the same way in different states or countries. An LLC may have to register and pay fees in each state where it does business, and it may face different tax rules and liability laws in different jurisdictions.
A cooperative is a legal structure where a group of people or organizations work together to achieve a common goal. A cooperative is owned and controlled by its members, who share the profits and benefits of the business. A cooperative is created by filing articles of incorporation with the state government and paying a fee.
The main advantage of a cooperative is that it promotes democracy and cooperation among its members. Members have equal voting rights and decision-making power in running the business, regardless of their contribution or investment. Members also enjoy tax advantages, as they pay taxes on their share of the profits on their personal income tax return.
The main disadvantage of a cooperative is that it may face challenges in raising capital and attracting talent. A cooperative may have limited access to external financing, as lenders or investors may not be willing to lend or invest in a business that does not have clear ownership or control. A cooperative may also have difficulty in hiring or retaining skilled workers, as they may prefer to work for a business that offers higher salaries or incentives.
7. Nonprofit Organization
A nonprofit organization is a legal structure where a business operates for a social, educational, religious, charitable, or other public benefit purpose. A nonprofit organization is created by filing articles of incorporation with the state government and paying a fee.
The main advantage of a nonprofit organization is that it serves a noble cause and makes a positive impact on society. A nonprofit organization also enjoys tax exemptions, as it does not pay taxes on its income or assets, and it can receive tax-deductible donations from individuals or corporations.
The main disadvantage of a nonprofit organization is that it has to follow strict rules and regulations to maintain its tax-exempt status. A nonprofit organization has to operate exclusively for its stated purpose, and it cannot engage in any political or lobbying activities. A nonprofit organization also has to disclose its financial information and activities to the public and the IRS.
Choosing the right legal structure for your business is a crucial step that can affect your success and sustainability. There is no one-size-fits-all solution, as each legal structure has its own advantages and disadvantages. You should consider your goals, needs, risks, and resources before making your decision. You should also consult with a lawyer, an accountant, or a business advisor to get professional guidance and advice.
Legal Structure of a Business: A Global Perspective
The legal structure of a business refers to the type of entity that owns and operates the business. It determines how the business is taxed, how it can raise capital, and how it is liable for its debts and obligations. Different countries have different legal structures for businesses, and some of them are more popular than others.
According to a report by the World Bank, the most common legal structure for businesses worldwide is the limited liability company (LLC), which accounts for 54% of all registered businesses. An LLC is a hybrid entity that combines the features of a corporation and a partnership. It provides limited liability protection to its owners, who are called members, and allows them to choose how they want to be taxed.
Another common legal structure is the sole proprietorship, which accounts for 22% of all registered businesses. A sole proprietorship is the simplest and cheapest form of business, where one person owns and runs the business. The owner is personally responsible for all aspects of the business, including its taxes, debts, and liabilities.
A third common legal structure is the partnership, which accounts for 9% of all registered businesses. A partnership is a business owned by two or more people who share the profits and losses of the business. There are different types of partnerships, such as general partnerships, limited partnerships, and professional partnerships. Partnerships are usually easy to set up, but they also expose the partners to unlimited liability for the actions of each other.
Other legal structures that are less common include the corporation, which accounts for 7% of all registered businesses, the cooperative, which accounts for 4%, and the other category, which accounts for 4%. A corporation is a separate legal entity that can own assets, sue and be sued, and issue shares to raise capital. A cooperative is a business owned and controlled by its members, who benefit from its services or products. The other category includes various legal structures that are specific to certain countries or regions, such as foundations, associations, trusts, etc.
The choice of legal structure depends on various factors, such as the size, nature, and goals of the business, as well as the legal and regulatory environment of the country where it operates. Some legal structures may offer more advantages than others in terms of tax efficiency, liability protection, flexibility, and access to finance. However, there is no one-size-fits-all solution for every business.
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