After lots of dreaming and planning, you’ve decided to start a business. You’ve chosen a name, identified target customers and have a color scheme for your website ready to go. But before you get too excited, there are many additional considerations to be made. One of the most important is deciding on a business structure for your enterprise.
Why Your Business Structure Matters
According to the Small Business Association (SBA), your business structure impacts:
- paying taxes (no longer your employer’s responsibility)
- personal liability (your business may incur debt or be sued)
- paperwork filing required
- raising capital
The SBA stresses the importance of choosing a business structure as soon as possible as many other important pieces of your business hinge on it. Without knowing your structure, you can’t:
- register your business with your state
- apply for a tax ID
- open business banking accounts (the tax ID is a requirement for this)
While you can change your business structure down the line, the SBA cautions that this may not be a simple process. If you think this decision through at the onset, accounting for present and future business needs, you could save yourself a lot of trouble years from now.
Each structure has its pros and cons. Your situation, preferences and business vision will dictate the best option for you.
According to the IRS, the most common business structure types are:
- Sole Proprietorship
- S Corp
- Limited Liability Company (LLC)
Note: There are other, business structures outside the scope of this article. You can read more about limited liability partnerships, non-profit, B Corp, and Cooperative (Co-op) business structures by following the links.
Let’s look at each in turn.
Description: As the name implies, this is a one-person business. The owner has complete control. Freelancers who haven’t formed an LLC generally fall into this category.
Taxation: Taxation occurs on the business owner’s personal tax return.
Liability: The owner assumes all liability for the business.
Paperwork: There is a relatively small paperwork requirement for starting and maintaining this type of business.
Pros: The owner has total control. The entity is easy to form. Taxation is simple, and business losses could offset income from other sources.
Cons: The owner is on the hook for anything that happens in the business. It is also harder to raise capital for sole proprietorships as banks may be less inclined to give out loans.
Description: A partnership — either general or limited — involves two or more people who’ve agreed to go into business together. Each partner makes an investment into the business for a stake in the business’ future performance.
With a general partnership, all partners have chosen to take part in actively managing the business and sharing in the profits and losses.
A limited partnership involves two types of partners — general and limited (or silent). General partners own, operate, and assume liability for the business; while limited partners are merely investors. Limited partners are not actively involved in operating the business and any liability is limited to the amount of their investment.
Taxation: While a partnership must file an informational return containing a breakdown of their financials, actual taxation occurs on each partner’s personal return.
Liability: The partners assume all liability for the business.
Paperwork: There is a larger paperwork requirement here than with a sole proprietorship. Initially, a partnership agreement should be drafted so that everyone is clear on each partner’s responsibility, stake in the business, and how the partnership will operate under certain circumstances. There are also more tax forms to file.
Pros: Partners can pool resources and ideas to start and grow the business. Partnerships also do not pay taxes as distinct entities (like corporations do).
Cons: Discord within the group can significantly impact partnerships. A good partnership agreement can help clarify misunderstandings, but many partnerships fail due to internal strife or the rogue actions of one or more of the partners. Additionally, the partners are personally liable for what goes on in the business (unless they are limited partners).
Description: A corporation forms when shareholders (owners) buy capital stock in the company. It becomes its own entity, separate from the shareholders.
Taxation: Taxation occurs twice with a corporation. The corporation is taxed on its profits and the shareholders are taxed on the dividends they receive. Moreover, the corporation cannot deduct the dividends they pay out, nor can the shareholders deduct for the losses of the corporation.
Liability: The corporation assumes all liability for the business, protecting the shareholders/owners personal assets.
Paperwork: The paperwork to form a corporation is extensive and includes articles of incorporation and bylaws. The corporation also needs to document yearly meetings and file annual reports.
Meticulous financial record keeping showing the distinction between corporation and owner finances is also a must. Failure to follow requirements could result in the loss of liability protection, meaning that owners will be personally liable, like with partnerships and sole proprietorships.
Pros: The biggest pro is the liability protection.
Cons: The biggest con is the double taxation, with all of the paperwork requirements and regulations closely following. Compliant corporations can be expensive and complicated to form and maintain.
Description: An S Corp is a corporation that avoids the double taxation of the standard corporation.
Taxation: The profits and losses of the S Corp flow through to each shareholder which they will report on their individual tax returns.
Liability: Like the standard corporation, shareholders/owners are shielded from the business liabilities.
Paperwork: The S Corp is subject to similar paperwork requirements as the standard corporation.
Pros: The S Corp avoids the double taxation of the standard corporation while retaining the liability protection.
Cons: Like the standard corporation, an S Corp can be costly from an administrative standpoint. There are also many restrictions that don’t impact standard corporations, such as shareholder limitations and stock issuance limitations.
Limited Liability Company (LLC)
Description: An LLC offers the tax filing benefits of a partnership with the liability benefits of a corporation. Formed at the state level, owners of an LLC are called members. Most states will allow single-member LLCs to form.
Taxation: Depending on the number of business owners and the paperwork filed, LLCs may be taxed as a sole proprietorship, a partnership, or a corporation. If the paperwork is filed accordingly, members avoid the double taxation of the standard corporation and the profits and losses flow through to their own tax returns.
However, LLC members will also have to pay self-employment taxes (Social Security and Medicare) on all profits. With an S Corp, owners only pay this tax on the profits they take as salary, rather than on the full profit amount.
Liability: Like a corporation, the LLC assumes the liability for the business.
Paperwork: There is some paperwork involved in forming an LLC. Articles of organization must be filed. And, depending on the state where you form it, an operating agreement may be a requirement.
Pros: The LLC is on the hook for business liabilities.
Cons: LLCs can be complicated if the company operates in multiple states. Each state has its own LLC regulations, so remaining compliant will take more time and money. LLCs also cannot issue stock nor can you pass them on to heirs.
Choosing a Business Structure
So how do you decide which structure is right for you?
Entrepreneur recommends thinking through the following with the help of a qualified professional:
- Risk Tolerance: How much risk will you encounter? Can you personally handle that level of risk?
- Tax Implications: How can you optimize your tax liability?
- Administrative Burden: What is the requirement for administrative work with each structure? Is it worth the hassle?
- Your Goals: What structure would help you meet those goals?
- Your Future Needs: What structure might be needed for future concerns?
If you conclude that your enterprise is low risk and you don’t want the administrative burden of a corporation or an LLC, you may elect to form a sole proprietorship or partnership.
On the other hand, if shielding your personal assets or passing on the company to an heir is important to you, you may elect to form a corporation.
This is a very personal decision involving many factors. It requires research and careful consideration to ensure your business starts off — and operates — as effectively as possible.
The intent of this article is to provide general information about business structures for entrepreneurs. It does not account for every detail as each structure type could easily have its own lengthy article.
Choosing a business structure is a nuanced decision and you may need additional guidance. Speak with a lawyer/CPA/other professional if you still have questions. They can help you dive deep into your financial situation, assess the level of risk that you’re undertaking, and form your business entity in a compliant manner.
Tell us: If you own a business, what structure did you choose and why?
Article written by Laura
Originally published at womenwhomoney.com on January 2, 2019.