Before a business plan is presented to funders, they would like to see that at least some low cost steps have been taken by the founders. One of these is to choose a legal structure for the business and to incorporate it, a process which generally costs only hundreds of dollars.
There are three major issues to consider when choosing a legal structure: control, liability, and taxes. Different legal structures have pros and cons on these three issues and you must seek what you are comfortable with and what will work best for the business both now and throughout its projected growth. The major legal structures to consider are sole proprietorships, partnerships, limited partnerships, corporations, and S corporations.
A sole proprietorship retains the greatest amount of control for the founder (100% of ownership control to be exact). Structures that allow for investors to take part mean an increasing loss of control from the founder. These include partnerships, corporations and S corporations. A limited partnership may be a good option for a founder who wants to retain control while bringing in outside investment. Limited partners (also called silent or sleeping partners) of the business have no say in how the business operates, while the general partners keep control.
It is important for a founder to discuss legal structures with a lawyer to understand their legal liability in various structures. Generally, as control is spread out from the owner, liability is also lowered. For example, a sole proprietorship has unlimited personal liability for the owner, as are partners in a partnership and general partners in a limited partnership. Limited partners are only liable to the extent of their investment and corporations and S corporations limit the liability of stockholders as well.
A tax accountant should be consulted to determine the best legal structure for tax purposes. Although you may have no profits to be taxed in the early years of the company, you will eventually be concerned with limiting your tax liability. Corporations are the one legal structure that causes double taxation on profits. This means that corporate profits are first taxed at the corporate tax rate and then dividends to stockholders are taxed at the going dividend tax rate. In other structures, profits flow directly to the shareholders or owners and are taxed at the individual tax rates. This is the advantage of S corporations, as they limit liability like a corporation but do not incur double taxation.