You’ve come up with a brilliant business idea and after some adjustments, you’re finally ready to make it official. It’s time to submit the final paperwork and take the world by storm. That’s when you hit a wall; what legal structure do you use? You’ve come to find that it’s not necessarily an obvious or cut and dry answer. In fact, the structure of your business can have wide-ranging effects on your operations.
This process can feel overwhelming to the point that you may consider just going down the path of least resistance instead of finding the entity structure that is best suited to your needs. But remember everything from taxes to how you can raise money and subsequent paperwork you’re required to file stems from this decision.
Of all the aforementioned considerations though, perhaps the most visible and noticeable one will be your taxes. Understanding how each structure affects what you’ll pay is vital. Broadly speaking, sole proprietorships and general partnerships make you and your business one legal entity where you pay personal income tax on profit. Depending on if you’re a C corp or S corp, your tax obligations change. C corps are double taxed, once on the corporate level, and once again on the personal level for the disbursed dividends. S corps allow for profits to pass through and be taxed on personal returns. LLC’s are a mixed bag and can be taxed differently.
In your research, it’s important to understand your options and strive to make an educated decision. This is precisely why it’s highly recommended that you consult an attorney or tax advisor for more information before moving forward in the process.
This is by far the simplest route to go and, as the name suggests, is meant for those folks who are starting a business as an individual. Technically, if you go into business without utilizing another structure, you’re considered a sole proprietor by default.
This is a good setup if you don’t intend to grow beyond yourself and the business is inherently low-risk.
- Ease of Setup and Low Cost – As previously mentioned, you would default to this structure and as such there are no forms or fees to pay. It’s simpler across the board.
- Total Control of the Business – You are the king of your castle and make all decisions. No need to consult with any other entity before making business decisions.
- Straightforward Tax Reporting – You essentially don’t have to file separately for yourself and your business. You would just need to file a Schedule C as part of an annual Form 1040.
- Liability – This is a big one. You and your business are one in the same so there is absolutely no limit to your personal liability in this structure. Your assets can be taken to settle debts or bankruptcy.
- Hard to Raise Funds – You can’t issue stock and banks/lenders are much more skeptical of lending to a sole proprietorship.
On a basic level, a partnership is when two or more people own a business and. From an ease of operation standpoint, a partnership classification is similar to a sole proprietorship. Partners share management responsibility, profits and in most cases, also unlimited personal liability. While there are many types of partnerships, the most common are general partnerships (GP), limited partnerships (LP), and limited liability partnerships (LLP). The largest differences between these subtypes are related to liability.
Partnerships are well suited for law and real estate practices.
- Ease of Establishment – A general partnership is created by default if no other business structure is filed. To form limited partnerships require a fee and a bit of additional paperwork to define ownership.
- More Expertise – By the nature of having more people to bounce ideas off of, you naturally have more heads in the game. Two, three, four, etc. heads are better than one. You’ll also likely have people with diverse skillsets and strengths that can tackle your areas of weakness.
- Pass-Through Taxation – Just like a sole proprietorship, partnerships are a pass-through entity which means the business itself isn’t taxed because income is passed through to the individual partners.
- Liabilities – In a general partnership, all partners are fully responsible for liabilities of the business and each other’s actions (i.e. if one partner is sued, the rest are still liable). In limited partnerships, where limited partners are often just investors, they are only liable up to the investment they make.
Beyond sole proprietorship, a huge caveat for all business entities of more than one individual liability. It’s crucial to create an agreement between yourself and your partners. When you’re starting out, you tend to agree on a lot and things feel like everyone contributes to a shared goal. However, more often than not as your business grows so too do the goals and views of the business by all involved. This can often lead to arguments and conflict which can get costly. This is especially true if you don’t have an underlying agreement in place that discusses how to handle these issues.
Corporations are much more complex and expensive than the comparatively simple structures listed above. Like partnerships, there are many types of corporations but the most common are C corps and S corps. The chief distinction of both of these is that they are entirely separate legal entities from you as an individual. They have their own legal rights, can sell stock, be sued, etc… And because, for all intents and purposes, they are a separate person, they provide the most protection from personal liability.
All corporations technically begin as C corporations and typically have the familiar organization of issuing stock and shareholders who elect directors to oversee the business. C corps pay tax on profits at their corporate rate and any profits distributed to shareholders in the form of dividends are then subject to being taxed again at that individual’s tax rate. Double taxation is not necessarily ideal but this type of entity has its benefits.
C corps are generally best for large companies intending to be publicly traded.
- Liability Protection – Due to the fact this is an entirely separate entity, this offers the strongest personal liability.
- No Limit to Ownership – You can have as many shareholders as you’d like both domestically and abroad.
- Raising Funds – Issuing and selling stock makes raising capital much easier.
- Complicated – There are a lot of additional filings and paperwork (articles of incorporation, corporate minutes, etc.) that go into creating and maintaining a corporation.
- Expensive – With the abundance of paperwork comes the fees and experts you would pay to guide you through the process. Corporations are pricey to start and maintain.
- Double Taxation – Arguably the biggest issue, C corps pay tax on profits at the corporate level, and then those after-tax profits are taxed again when disbursed to shareholders.
An S corp is very similar to the C corp in general but there are some notable differences, chief among them and most important is the issue of taxation.
To convert a C corp to an S corp requires the submission of Form 2553 to the IRS. Small to medium-sized businesses might find this structure advantageous as it combines the liability protection of a C corp with the ability to avoid double taxation.
- Taxation – As noted, S corps are pass-through entities and therefore are only taxed once.
- Limited Shares – You can only have up to 100 shareholders.
- No Foreign Ownership – All shareholders must be U.S. citizens.
While seemingly subtle, the differences between a C and S corps are important to understand.
A limited liability company is, broadly speaking, a mix of all the aforementioned structures, a hybrid. Its main purpose is ultimately to limit liability for ownership, as the name suggests. In practice, it most closely resembles an S corp.
An LLC is a quality option for the type of business that has a higher risk and employed across businesses of all sizes but more typical for small and medium-sized.
- Pass-Through Entity – Profits and losses can be passed to you personally.
- Less Paperwork – Corporations require a lot of added paperwork and procedures which are absent from the LLC business structure. Beyond articles of incorporation, there aren’t many of the regular reporting requirements.
- Tax Requirements – Members of an LLC are viewed as being self-employed so each one is individually required to pay self-employment tax and make contributions to Social Security. Similar to a sole proprietorship.
- Cost – While less expensive than a corporation, the fees for starting an LLC are markedly higher than partnerships and sole proprietorships.
As you can see, there are quite a few entity structure options available, some of which unsurprisingly overlap. It’s important that you pick the right business type and don’t forego choosing a formal business entity altogether, thinking that you might not need it. Defaulting to a sole proprietorship or general partnership, which is what would happen if you didn’t formally declare another structure, might not be the most advantageous route for you to go. In fact, the liability exposure in those two options could be downright dangerous for you and your business.
Speaking of liability, you’ll notice it varies a bit between a sole proprietorship/partnership, corps, and LLC’s. It’s worth noting that regardless of the level of liability protection you think you have, your business entity will not protect you and your assets against all risks. You’re not protected from being negligent or committing wrongful acts for example. There are many forms of business insurance to look into that will cover you in other situations. For example, errors and omissions insurance and general liability insurance.
Ultimately, each business type has its distinct advantages and disadvantages. At the end of the day, it’s crucial to have a deep discussion with your attorney or tax advisor before making this decision. Through this process, you’ll be well on your way to moving forward in your new business endeavor. This step will eventually aid you in the next step of acquiring a merchant account for your organization’s credit card processing.