A Primer on Legal Structures


I am not a lawyer, but knowing how your company is organized as part of the CFO’s job. More importantly, knowing how the various legal structures impact everyday decision-making – from how your financial statements should look, to what tax forms you file- is critical.

What are the primary differences between sole proprietorships, limited liability companies, and corporations?

With a sole proprietorship, the owner and the business is one in the same. There is no distinction. Thus, the sole proprietorship can only have a single owner, the actual sole proprietor. As such, the profit and losses of a sole proprietor are recorded in Schedule SE—Form 1040. Generally, this is called pass-through taxation, as this schedule is included in the owner’s personal income tax filings. In this situation, the profit and losses of the business are literally passed through to the owner. Additionally, as there is no distinction between the owner and her business, the business’s liabilities are the owner’s liabilities.

A limited liability company differs from a sole proprietorship in two main ways. First, the LLC could have more than one owner, whereas a sole proprietor only has one owner. Secondly, the LLC is a separate and distinct legal entity than its owners. This concept is called corporate personhood, and this is important because, if the LLC owes another party money, generally the owners are not personally liable.

A corporation differs from an LLC in one primary way. A corporation, generally, files its own tax returns. The federal return for a U.S. corporation is Form 1120. Generally, the owners of the corporation receive profit distributions by means of dividends. There generally is no pass through accounting on corporations.

At what point should an entrepreneur consider forming an LLC?

The first reason entrepreneurs should consider forming an LLC is if they do not wish to be personally liable for the activities of their business. If an entrepreneur has no tolerance for personal risk, then he should contemplate forming an LLC from day one and consider the additional expenses an investment in protecting personal assets.

The second reason an entrepreneur should consider forming an LLC is when the sole proprietorship would like to have more than one owner. The third reason an entrepreneur should consider forming an LLC is when the sole proprietor has employees and would like to offer those employees certain benefits. A sole proprietorship cannot provide the range of tax efficient benefits, such as a 401k, to its employees that an LLC or a corporation is able to under current regulations.

What are the financial benefits and costs of an LLC?

In Massachusetts, as sole proprietor, you’re required to register your business with your city or town. There is a small cost associated with this. Generally, a sole proprietor with some financial literacy or experience could prepare her own Schedule SE on her own personal income taxes.

As an LLC, you must register with the Commonwealth of Massachusetts Department of Corporations and will need to pay a qualified attorney to draft formation documents and operating agreements. Also, an LLC generally needs specialized tax accounting, as profits are distributed to members according to the operating agreement. Whereas a sole proprietor with some level of sophistication could file his or her own Schedule SE, the vast majority of small business owners outsource entirely the tax filing and distribution calculations for an LLC.

There are vast differences in the personal liability limits of the business owner. Regardless of the structure, each company should seek to invest in business liability insurance. Talk to a qualified commercial insurance broker and get insurance to protect yourself. There are packages meant for self-employed sole proprietors, and it’s well worth the investment.

What provisions do you recommend business owners include in their operating agreement when forming an LLC?

I recommend including two key areas:

  1. Distribution of profit and losses. How are the proceeds of the company distributed to the members? Specifically, what is the math behind allocating the profits and losses of the LLC to the owners?
  2. Adding new members and rights of departing members. If a member were to depart, due to death or otherwise, the LLC should know in advance how things will proceed. Do the existing members have the rights to buy out the departing owner? Would it be a certain price? Also, how does the corporation take on new members? What is the cost of each unit of membership, or what is the process to determine the cost

This article was written by Gillian Burdett for CBS Small Business Pulse. I was interviewed by Gillian Burdett, where it is still posted.