Legal Structures for Contractors

 

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There are four different core legal structures a contractor may select. Each has its own restrictions, advantages and distinct issues requiring knowledge to ensure the best selection. This article will cover the four different structures and the variables that give it advantages over the others. Each structure works well given certain underlying conditions. For a contractor, selecting the right structure will assist in maximizing profit and generating smooth operations.

The four different legal structures are:

  1. Sole Proprietorship
  2. Limited Liability Company
  3. Partnership
  4. Corporation

There are variances to each of the above, but each represents a distinct way of legally operating your construction company.

Prior to exploring each of the core legal structures, a contractor needs to understand a simple legal relationship that exists in business. Legal protection afforded by two of the structures (Limited Liability Company and Corporation) does not exist to the extent many people believe. Lawyers don’t explain the legal protection status well because it is very complicated. But in general, suppliers, insurance companies, banks and any third party will have the contractor sign away this state protection in the contracts and agreements when forming the relationship. The result is that this legal protection is extremely limited. The absolute best forms of protection are good operating policies along with documentation. Other tools to minimize lawsuits include:

  • Insurance
  • Human Resources Management
  • Well Drafted Construction Contracts 
  • Documented Communications
  • Proper Project Management
  • Risk Shifting
  • Supplier/Subcontractor Agreements
  • Common Sense

 

Sole Proprietorship

This is by far the simplest and easiest form of legal existence. Without any application to the state government, your construction operation is automatically a sole proprietorship. There are several advantages to this legal structure. First, you do not need any documentation, the company’s name is automatically your name. You may file for a fictitious name with the state or circuit court; but legally, all activity is under your personal name. This form of legal structure also makes it easy with the Internal Revenue Service to file taxes and conduct business.

Every lawyer will tell you that this is not a good idea due to our litigious society. However, as cited above, there are several actions a contactor can take to eliminate this risk. Interestingly enough, a contractor should take all those steps anyway in order to run a solid organization. The author endorses this type of legal existence under certain conditions:

  • Just starting out in business;
  • Anticipated revenues of less than $500,000 per year;
  • Carrying a Limited Contractor’s License;
  • No Employees; OR
  • Contracts are limited in scope.

Advantages for this form of legal structure are significant savings associated with maintaining a franchise (business license) with the state, reduced taxes and lower compliance costs.

Limited Liability Company (LLC)

As a contractor grows and the scope of services broaden to include additions and new construction, it is time to consider modifying the legal structure. The number one reason to gain a higher level of protection is due to employees. It is nearly impossible to safeguard against stupidity, egos and inexperience. Employees create the greatest risk for a contractor and thus a different legal structure is warranted. 

A simple form of legal existence is the limited liability company. This requires application and acceptance by the state government, often through the Secretary of the State where the business is domiciled. It does require annual renewal upon granted status from the state. This legal structure protects the contractor from disgruntled employees or worse, their negligence while on site working. In effect, the justice system will limit the ability of the employee or the injured party to pursue the contractor as an individual in a lawsuit. The monetary reward is pretty much limited to the insurance proceeds and rarely impacts the financial status of the company other than legal fees.

As stated in the opening paragraphs above, third party financing of any sort (suppliers, subcontractors, banks and government authorities) will have the contractor sign away these rights or the rights are taken away under legal regulations. Furthermore, the contractor’s building license is typically a personal license and exists outside of the legal entity structure. Thus, legal protection is severely limited, but this form of legal structure works well as a shield against employee actions.

Partnership

This is by far the most flexible of all legal forms of existence. If a contractor combines a limited liability company with a partnership whereby the LLC hires all employees and charges the partnership for the employee services; the legal structure achieves maximum flexibility to raise capital and manage the overall organization. A partnership allows for more than one individual in the organizational ownership. Each owner can have their own unique relationship to the company and associated financial reward understanding. 

The key to a partnership is a well written partnership agreement stipulating the ownership, management and financial relationship among the respective partners. Although much more complex to create and set in place, this form of legal structure is sophisticated in allowing the contractor to grow. The best time to implement is when revenue exceeds $10M per year or the contractor wants to get involved in development of projects. The disadvantage is the need to constantly update the partnership agreement and maintain compliance. Legal fees can exceed $15,000 per year just to have this form of legal structure.

Corporation

A well recognized form of legal existence is the corporate structure. Upon application, the state provides a charter, a legal grant of existence. This in effect creates a separate legal entity recognized by the justice system. This legal entity can sign contracts, engage in business, hire employees and more. If sued, the plaintiff must sue the legal entity and not the contractor as an individual. However, just as noted in the LLC above and at the beginning of this article, most third party financing requires a guarantee from the primary shareholder(s) (owner(s) to pay any open balances if the corporation fails to meet its financial obligations. Thus the bankruptcy protection doesn’t really exist for the owner(s), only lawsuit protection exists.

Again, as stated above, the absolute best protection from lawsuits of any sort is a set of good policies and the corresponding documentation. Insurance compliments good policies.

This form of existence is actually superior to the LLC if there is more than one owner for the company. Why? A shareholder’s agreement is much easier to draft than a multi-member agreement under the Limited Liability Corporation structure. Furthermore, the shareholder’s agreement has had more legal testing done with the courts than membership agreements (LLC arrangements) and therefore outcomes have greater certainty than membership agreements.

Conclusion

If starting out, keep it simple by exercising the sole proprietorship form of legal existence. Once a contractor starts to hire employees and their contractor’s license level increases, shift to the Limited Liability Corporation form of organization. This will eliminate the most significant risk associated with owning a business – employees. If others will participate in ownership, shift to the corporation form of existence. This will maintain the protection from employees and keep the ownership structure simple.

If the company grows beyond $10M per year and/or carries several licenses, discuss with a business attorney changing the organizational legal structure to the more sophisticated partnership arrangement and have employees hired under the corporation or LLC to protect the partnership from this major risk. Use good policies and documentation to prevent and eliminate risk. Utilize insurance to compliment risk exposure and finally; use some common sense when organizing your construction company. Read more information on this website that explores each of these legal structures in more detail. ACT ON KNOWLEDGE.

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