When to Change Your Legal Structure

Starting a business entails the selection of the legal format of the organization-to-be. You can either choose to set-up your business as a sole proprietorship, partnership, corporation, S corporation or limited liability company — all of which has its own advantages and disadvantages. The legal structure you choose will determine how much paper work you will have to do, how much personal liability you will incur, how much you will be able to raise money, and how your business will be taxed.

One of the common mistakes of small and home-based business owners is to rush to immediately incorporate the business. They go through the paperwork and expenses to form their corporation — only to find that there’s no profit to be made from their business idea. So instead of a simple dissolution as a sole proprietorship allows, they have to go through the formal process (and lots more paperwork!) of dissolving the corporation-that-never-was.

It is important to understand that the legal form that you choose for your business at the start-up need not be cast in stone. You can always change your legal structure depending on how your circumstances have changed. You can always reexamine if the legal form of your business remains adequate based on your current situation and the growth of your business.

Here are some examples of reasons why the structure must be reconsidered from time to time:

Need to raise additional capital from multiple investors for business expansion. It is easier to persuade 10 people to put in $5,000 than to convince one person to invest $100,000, and a corporation allows for this kind of widespread ownership.
Changes in applicable tax laws. Weigh in the advantages of changing your legal structure on your tax liabilities.
Increase in risk due to additional dealings with creditors, suppliers, or consumers. As the risks of your personal liability increases, you may wish to change shift from a sole proprietorship to a corporation.
Shift in business plans that have an impact on the distribution and use of earnings and profits.
Opportunities to develop new technology, either in conjunction with others or under the umbrella of a separate but related subsidiary or research-and-development partner.
Retirement, death, or departure of an original founder
Need to attract and retain additional top management personnel
Mergers, acquisitions, spin-offs, or an initial public offering planned for the near future

These are some of the factors that could affect the structure of your business as it grows and evolves. Your business will go through phases, and a different legal structure may be appropriate for various stages in your company’s life cycle.

For example, in its very early stages, your small retail business may start out as a sole proprietorship. Many home-based and small businesses start out in unincorporated form so that business losses in the early years of business can shelter other incomes. These “passed through” losses can be used to offset other income you may have. The drawback though, is that sole proprietorship is the most restrictive form of organization for financing because its total capital is limited to whatever personal funds you are willing to contribute, and whatever you can borrow against personal assets.

Once the business is opened, the desire to give some ownership to a spouse, family member, friend or a key employee may result in a shift to a general partnership. Then the need to bring in a passive investor to support procurement of equipment may result in a shift to a limited partnership.

Your business may incorporate when the operation becomes profitable, to better protect the assets of all partners against claims and liabilities to third-party creditors. You may elect the S-corporation status to preserve “pass-through” taxation. If the company considers growth through business format franchising two years hence, the decision could be made to form an LLC to handle the franchise operations and to better insulate the assets of the two “company-owned” stores.

Making the best decision about business structure early could save you money and avoid costs down the road. If you are unsure about which type of business structure is best for your business, consult an attorney who is knowledgeable about the various types of business organization. It is critical for anyone starting a new business venture to consult with qualified legal and tax advisers before making the decision of the legal structure of the business.

Recommended Books on Legal Structure

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