Are You Operating Under the Right Legal Structure?

Analyze whether a sole proprietorship, partnership, LLC, or corporation is still the right fit for your business.

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Many businesses start out as sole proprietorships or partnerships because they are the simplest to form. That may have been fine when your business first opened its doors, but it pays to check in and see if your current legal structure is still a good fit for your business -- especially when it comes to tax breaks and personal liability -- or whether it's time to step up to a limited liability company (LLC) or corporation. Answer these seven questions to find out.

1. Has your business become engaged in risky activities?

Certain businesses -- a hazardous waste cleanup company or building demolition contractor, for example -- are inherently riskier than others (see Nolo's article Risky Businesses for other examples). If your business is starting to engage in risky activities, that may be reason enough to convert your business to a corporation or LLC. That's because by incorporating or forming an LLC you get the protection of "limited liability," meaning your personal assets are shielded from business-related debts and claims.

For more information on liability protection and selecting the best legal structure for your business, see Nolo's articles Learn About Business Ownership Structures and Choosing the Best Ownership Structure for Your Business.

2. Have your personal assets grown since you started your business?

If you now have a significant amount of personal assets, that may also be reason enough to convert your business's legal structure to an LLC or corporation. Without the limited liability protection offered by these business forms, your personal assets will be at risk if your business can't pay off its debts or satisfy court judgments entered against it.

To learn more about how an LLC or corporation can help you protect your personal assets, see Nolo's articles LLC Basics and Corporation Basics. For information on when an LLC or corporation might not shield you personally, read Nolo's article Personal Liability for Corporate Debt.

3. Will business insurance cover the risks of your business?

Your business may be able to protect itself against certain risks through insurance. For example, you can use an insurance policy to guard against work-related car accidents involving your employees. If it looks like the right business insurance policy will cover most of your business's risk, then converting to an LLC or corporation may not be warranted. Unless there are other compelling reasons to convert to and maintain an LLC or corporation, save yourself the expense and paperwork, and just stick with the status quo.

To learn more about business insurance, see Nolo's article Obtaining Business Insurance.

4. Are you thinking about sell stock to investors or issuing employee stock options?

If you're thinking of taking the next step by raising investment capital by selling stock -- or issuing stock options to attract and retain key employees -- you would have to first convert your business to a corporation. While it's true that LLCs can raise capital by selling membership interests, the process of doing this is more cumbersome than issuing stock, particularly if you expect to have multiple investors or want to raise money from the public. 

Another benefit of issuing stock is the ability to make gifts of stock to family members as part of an estate plan. You can easily make gifts of corporate shares without giving up management control and, if you do it correctly, you can avoid paying a gift tax.

For more on the differences between LLCs and corporations when it comes to issuing stock, see Nolo's article Corporations vs. LLCs.

5. Has your business started to turn a good profit?

If your business is now bringing in some money, you could save some income tax dollars by converting your business to a corporation and keeping some of your profits in the corporation each year. The profits left behind (called the "retained earnings") would be taxed to the corporation at corporate income tax rates (15% on the first $50,000 of profit and 25% on the next $25,000 of profit), which are lower than most business owners' individual income tax rates. However, the tax savings alone -- probably a few thousand dollars -- may not be worth the hassle of converting to a corporation and filing a corporate tax return.

For more information on corporate taxation, see Nolo's article How Corporations Are Taxed.

6. Do you want to start providing extensive fringe benefits to yourself or your employees?

Another tax benefit of corporations is that they can deduct the full cost of fringe benefits (like health insurance and reimbursement of medical expenses) that are provided to employees (including owner-employees), and the employees and owner-employees don't have to pay any tax on the value of these benefits. Other types of business entities can also deduct the cost of many fringe benefits as a business expense, but the owner-employees who receive these benefits will ordinarily be taxed on their value.

To find out how different business entities are taxed, see Nolo's articles How Sole Proprietors Are Taxed, How Partnerships Are Taxed, How Corporations Are Taxed, and How LLCs Are Taxed.

7. Are you worried about retaining independent contractor status?

If you're an independent contractor and want to ensure the IRS or other government agency doesn't reclassify you as an employee, you may want to incorporate. Because reclassification is highly unlikely for incorporated independent contractors, your clients may also insist that you be incorporated before they hire you.

For other tips on retaining independent contractor status, see Nolo's article Preserving Your Status as an Independent Contractor.

More Information

Once you decide it's time to upgrade the legal structure of your business, LLC or Corporation?, by Anthony Mancuso (Nolo), will help you decide which legal structure is right for you and will walk you step-by-step through the process of converting your business entity.

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