So you’ve come up with a promising idea and crafted a solid business plan.
Now it’s time to choose a legal structure for your enterprise.
The stakes are high: Your business structure determines how your company will be taxed, the amount of paperwork you’ll be required to complete, and whether your personal property is considered separate or conflated with your business property. It can also affect your ability to raise capital.
Your decision should be based on your answer to these three questions:
1. How much tax preparation are you willing to take on?
2. How willing are you to risk your personal assets for the business?
3. Where do you expect your business to be in five or 10 years?
Below is a look at the five most common types of business structures, designed to help you as a business owner choose the appropriate one for the needs of your business—now and down the road. While specifics may vary from state to state, the most common business structures have the same general characteristics across the country.
A sole proprietorship is the simplest business structure—it typically involves a single person who owns and operates the business. As a sole proprietor, you are personally responsible for your company's liabilities. If there is a business debt or legal claim filed against your business, your personal assets would be at risk.
- Advantages: Your business earnings are taxed only once, and you maintain complete control over your business and related decisions.
- Raising Capital: It can be difficult to raise capital as a sole proprietor, because many leaders are unwilling to make business loans to sole proprietorships.
- Taxation: Business earnings or losses are "passed through" to be reported on your personal tax return. The expenses and your income from the business are included on your Form 1040, or personal tax return. Your business profits and losses are submitted on a Schedule C, which you simply file with your 1040. Any profits or losses are applied to the owner's personal tax liability. If you expect to owe at least $1,000 in federal taxes for the year, you are also required to make estimated tax payments. These payments are due throughout the year on April 15, June 15, September 15 and January 15.
- Added Complexity: You have to pay self-employment taxes, which are calculated on a Schedule SEand filed with your personal tax return.
As in a sole proprietorship, general partners are personally liable for the business. Each partner can take out loans and make decisions for the partnership that will be binding on all partners. A limited partnership encompasses both general partners who own and operate the business and assume liability for the partnership, as well as limited partners who are only investors with no control over the company.
- Taxation and Advantages: A partnership offers tax advantages by passing profits or losses through to the individual partners. The partnership must file a Form 1065 to report income and loss to the IRS. Each partner also reports his or her share of the income or loss on a Schedule K-1.
A corporation is an independent legal entity that is separate from its owners. Owners have protection from liability and are not considered responsible for a corporation’s debt, so personal assets are not at risk.
- Advantages: A C-corporation is best leveraged by large companies. If you want the benefits of a corporation with some of the ease of a small business structure, consider an S-corporation (more in the next section).
- Raising Capital: A corporation can sell stock to raise funds and also keep some of its earnings without taxes being levied against the owner.
- Taxation: As an owner of a C-corporation, you may pay double taxes on company earnings. The corporation must pay corporate income tax, and any earnings you take from the company will also be taxed at your individual rate on your personal tax return.
- Added Complexity: If you own a corporation, you must comply with more complex regulations and tax requirements than other business structures. Translation: Owning and managing a corporation is more expensive because you’ll need extensive legal, accounting and tax preparation services.
An S-corporation offers some tax benefits as well as the liability protection of a corporation.
- Advantages: If your S-corporation doesn’t have inventory, you can use a cash rather than accrual method of accounting. The cash method is much simpler—income is taxable when received and expenses deductible when paid.
- Raising Capital: Because S-corporations can have up to 100 shareholders, you can attract more investors for more capital. And while S-corporations can issue stock, the IRS places a number of restrictions on the type of stock and who can own it.
- Taxation: In an S-corporation, income and losses are passed through to you as well as any other shareholders and included on your individual tax returns.
- Added Complexity: S-corporations do pay higher costs for legal services and tax preparation.
Limited Liability Corporation (LLC)
First developed to provide business owners the liability protection of a corporation without the double taxation, LLCs allow you to have as many shareholders as you want and any member of the LLC can fully participate in the operation of the business.
- Advantages: LLCs have some flexibility on structure. You can choose, for example, to structure your business as a Single-Member LLC (SMLLC), which establishes you as the sole owner of the LLC business. This allows for a tax structure that is similar to a sole proprietorship, while providing the liability protections of an LLC.
- Raising Capital: LLCs with an established track record of revenue and business credit will have an easier time obtaining funding. However, it can be more difficult for SMLLCs because the risk is less evenly distributed.
- Taxation: Unless you choose to be taxed like a corporation, your LLC's profits pass through to you and any other owners, and are included on your personal tax returns.
- Additional self-employment taxes:If your LLC operates as a pass-through entity, you’ll have to pay self-employment taxes—including your own share of federal items like Medicare and Social Security.
- Added Complexity: Setting up an LLC requires you to file articles of organization with the state where you intend to do business. And LLCs don't last forever: Some state laws require the company to dissolve after 30 years or when a member dies or leaves the company.
How to Choose the Right Structure for Your Business
While some of the benefits crossover from one business structure to the next, the main determining factors will likely be liability and tax related. With that in mind, there are few key points to remember:
- Sole proprietorships have the simplest tax filings, but don’t offer the same protections as other business types.
- If you plan to take on business debt or operate in a litigious industry, it’s probably best to choose a business structure that offers protection for your own assets.
- If your goal is to build a larger business, it may make sense to start out with a structure that will continue to work well for a bigger business. Review your financial projections and business plan with a financial professional to get a sense of your company's tax, lending and liability needs for the future.