Legal Structure

5 signs your business has outgrown its legal structure

4 min read
Nellie Akalp

As your business matures and grows, the legal structure you chose as a startup might no longer be the right fit. This happens most often to entrepreneurs who start as sole proprietorships or partnerships, but even LLCs and S corporations sometimes discover they’d benefit from making a change.

Here are five signs that might indicate “yes.”

1. You’re adding employees.

With employees, you are not only responsible for your own actions, your business also assumes some liability for what members of your team do. That means liability protection may be in order. Changing to an LLC, S corporation, or C corporation provides separation between your personal assets and your business. In the event (heaven forbid!) of a lawsuit against your business, forming an LLC or incorporating helps ensure your personal property will not be at risk.

2. You’re getting hit hard on your personal income tax returns.

Legal Structure Taxes

One of the potential advantages of operating as a sole proprietor, partnership, or LLC is the simplicity of pass-through taxation. Your taxable business income flows through to your personal income tax return. But as your company’s profits increase, this can become costly. Because sole proprietorships, partnerships, and LLC members are both employer and employee in their businesses, both payroll and income taxes apply to their net income. Paying the full 15.7 percent of Social Security and Medicare taxes on that net income can hit the bank account hard!

By incorporating as an S corporation, you can potentially reduce your tax liability.

As an owner, you would pay yourself a fair salary. While your wages would be subject to payroll and income taxes, any portion of your business’s profits that you take as distributions would not pay Social Security and Medicare taxes. This could save you a significant amount of money each year.

3. You’re bringing on a partner/co-owner.

When operating as a sole proprietor, you alone may be the owner of your business. So if you plan to add a partner or co-owner, you’ll need to change your legal structure to some form of partnership, LLC, or corporation.

4. You want to seek funding from investors.

If you want to raise capital from investors by selling stock in your company, you’ll need to incorporate your business. S corporations may sell shares to up to 100 members/shareholders. C corporations don’t have a limit on the number of shareholders that can invest in them. Also, C corps may be more attractive than S corps to outside investors.

5. You’re planning to retire or sell your business.

If you have your sights set on exiting your profitable business, you’re at a bit of a disadvantage when succession planning as a sole proprietor. Sole proprietors may not have multiple owners, so they can’t transfer or gift part of their business’s ownership to anyone else.

Sadly, when you operate as a sole proprietor, your business dies with you if you pass away.

When that happens, your estate inherits all of your company’s assets, potentially leaving your heirs with a massive tax liability.

Where do you go from here?

As you can see, many factors come into play when deciding which legal structure will best serve your company. Structures such as sole proprietorships, partnerships, and LLCs provide simplicity and less compliance headaches for small business owners, but they come with limited funding potential. And operating as a sole proprietor or partnership potentially puts your personal assets at risk if legal action is taken against your business. Corporations come with more business formalities and compliance requirements, but they offer more extensive personal liability protection, tax flexibility, and opportunities to raise money from outside investors.

To decide which business structure you should choose, educate yourself as much as possible about the pros and cons of each.

Consult an attorney and an accounting/tax professional who can provide expert guidance and help you evaluate your options. Finally, when it comes time to file the paperwork necessary to change your legal structure, make sure you complete and submit your forms accurately and on time. If you’re not comfortable doing this on your own, consider enlisting the help of a reputable company that provides business filing services or ask your attorney to handle it for you.

The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.