When starting your own business, you will need to decide on the business structure of your company. This decision will impact your taxes, how much paperwork you will have to complete, and your personal liability.
You should review each business structure wisely and choose the one that fits your business and personal needs the most.
Below is a brief overview of the types of business structures.
According to the Small Business Administration (SBA), a sole proprietorship is the simplest and most common structure to start a business.
Some advantages of forming a sole proprietorship are:
- It is easy and the least expensive to form.
- You receive all profits and do not have to share them with anyone.
- You will have complete control of the business.
- Taxes are easy to prepare.
- You can operate under a fictitious name, such as the name of your business.
Some of the disadvantages are:
- You are personally liable for all debts and can be sued if you don’t pay your bills.
- Raising capital and getting loans may be more difficult.
A partnership is a business with more than one owner who has not filed papers with the state to become a corporation or LLC (limited liability company).
There are three types of partnerships: general partnerships, limited partnerships, and limited liability partnerships.
- General partnerships – These are the most common and all partners play a role in the company. Every partner is personally liable for all debt.
If one person accumulates debt for the business, the other partner is equally responsible for paying that debt. If the business is sued for any reason, both partners are equally responsible.
- Limited partnerships (LP) – The partners who run the business have personal liability. They are responsible for all debts and contract obligations.
The other partners have limited liability. Those with limited liability have little control over the company. They are usually investors only.
Profits of the company are passed to all member’s tax returns.
The government does not tax the partnership. The investors report their profit and losses and declare income on their taxes. The partner with personal liability must pay self-employment taxes.
- Limited liability partnerships (LLP) – These partnerships give limited liability to all owners. An LLP protects each partner from debts and they are not responsible for the activities of the other partners.
Some states allow this, but usually, partners will form an LLC or incorporate instead of forming an LLP.
Many of the advantages and disadvantages are the same as a sole proprietorship if you don’t have limited liability.
Limited Liability Company (LLC)
An LLC is a business entity which lets you take advantage of the benefits of both corporation and partnership structures.
Some advantages of an LLC are:
- It is a good choice for medium-sized businesses or those with higher risk.
- It protects you from personal liability and your personal assets are not at risk if your business fails.
- The owners would only lose any money they have invested. Any business assets are used to pay off any debts.
- Usually members pay a lower tax rate than they would with a corporation.
LLC members must pay self-employment taxes and contribute towards Medicare and Social Security. Profits and losses are reported on the member’s personal tax returns.
The SBA also has information on the tax responsibilities for sole owners and multiple owners of an LLC.
Although an LLC has many advantages, you should research and understand the disadvantages as well such as:
- It is more expensive than forming a partnership.
- They usually dissolve if one of the members dies or leaves the company.
- An LLC can be more complex to set up and the rules may vary from state to state.
- It may be more difficult to raise capital since an LLC cannot go public.
An LLC must be set up correctly. If it isn’t set up correctly, a court might decide that the LLC doesn’t really exist and find that its owners are really doing business as individuals who are personally liable for their actions.
A C Corporation is automatically formed when a business incorporates.
Some of the advantages are:
- Individuals are protected from limited liability. Owners only lose invested money or assets.
- It is easier to raise money as investors can earn shares and dividends.
- Employees who are shareholders are exempt from paying taxes on any fringe benefits they receive.
- The business can continue to run if the owner should die or leave.
C Corporations have some disadvantages such as:
- They can be double taxed. They are taxed on their profits at the corporate level. Then, shareholders are taxed again on their personal taxes when they receive their distributions.
- Corporations also require more paperwork. You must create corporate bylaws, hold meetings, and keep minutes of the shareholder’s and director’s decisions.
- It must maintain a separate bank account from the owner’s account and it must keep detailed financial records.
Some of the advantages are:
- It protects the owners from personal liability.
- Like an LLC, all business profits pass through to the owners, who report them on their personal tax returns. This prevents the double tax situation as described in a C Corporation.
- The business can have up to 100 shareholders.
Some of the disadvantages are:
- They require much of the same paperwork as a C Corporation.
- If the company has shareholders, they will be taxed for any company income even if they didn’t personally receive any.
- S Corporations are only allowed to issue one class of stock, which may make it harder to raise capital.
- The IRS requires all officers and owners to make a salary even if the company is not making a profit.
If the S corporation has more than one owner, it must file an informational tax return to report each shareholder’s portion of corporate income.
The IRS has certain requirements for a business to qualify for an S Corporation. You should review those requirements and ensure you can meet the conditions.
Most states follow the federal guidelines on taxation of the S Corporation, but there are some who tax it like a C Corporation.
Every type of legal structure or business owner should consider liability insurance for their small business. This is especially important if your small business does not offer worker’s compensation or health insurance.
Even business structures with limited liability can be personally liable for certain things that happen. Understand your personal liability when setting up your small business.
In conclusion, you should consult a business attorney and a tax professional to understand the positives and negatives of each business structure. Think about the future of where you would like to go with your company. You may find that setting up an LLC or corporation may be better for your future needs.
Consider getting liability insurance for yourself regardless of what type of business structure you decide upon. Also, ensure you obtain the required licenses and permits for your company.
Regardless of what you decide, ensure you research and understand each business structure thoroughly.
Author: Kimberley Kay Travis
Kim Travis, co-owner of Travis and Adams Consulting Group, has over 20 years’ experience in human resources and leadership roles.
She has specialized knowledge in employment law, employee relations, recruiting, management consulting, leadership development, manufacturing safety programs, and writing business articles and blogs.