When setting up your business, there can be an overwhelming amount of decisions to make.
Everything from naming your business to choosing a business partner can feel like the most crucial choice in the world, only adding to the stress.
Let’s make one decision a bit easier; how should you structure your business?
Deciding what business structure fits you best may seem a bit complicated, especially when you think about tax implications, but with just a little information you can confidently make this decision.
In the following article, we go over the five main types of business structures. In reality, there are up to 14 different types of business structures, but they can get very specific.
We suggest reviewing this article and talking with your CPA about what decision may be best for you.
1. Sole Proprietorships
You are considered a sole proprietor if you own an unincorporated business and have not intentionally selected to be a limited liability company.
This means the owners bear full legal liability. Debts are the responsibility of the owner as much as they are the responsibility of the company.
- As the owner of the business you have complete control, limiting the number of legal hoops you may need to jump through and start-up costs.
- You also receive all the profits from the business, not requiring to share them with partnerships or shareholders.
- In the sense of taxes, you can offset business losses with personal income.
- Just as you are entitled to the profits, you also have the responsibility for the debts from the business.
Your personal property may be at risk from creditors if you do not own enough business assets.
Freelance workers or small businesses whose work requires little capital or those who offer services performed by the sole owner.
This is an easy option if you do not have any partners, shareholders, or significant expenses.
2. General Partnerships
A partnership is when two or more people come together to carry on a business.
This is similar to a sole proprietorship in that the profits and losses of the company are the responsibility of the owners.
The difference is they are shared among multiple owners.
- The partnership is not required to submit any incorporation paperwork with the Federal Government, saving on both time and money.
- Partners can also help one another by sharing in the liability and financial obligations.
- If there are not enough business assets to satisfy a claim to your creditors, they can go after personal property.
- Each partner has the responsibility of debt and liabilities owed by the partnership. This includes the debts of your partner.
This may not seem like a big deal, but we encourage you to pause and think about how much you trust your partner.
Are you confident in taking on possible debt they may incur?
General partnerships usually look like law firms, accounting firms, or medical practices.
When it comes to partnerships, the real risk is making sure you choose someone you can trust since you will be on the hook for liability incurred.
A corporation is a separate legal entity that is owned by shareholders. In forming a corporation, shareholders come together and exchange their money and property for capital stock.
The corporation is taxed, as are the distributions paid to its shareholders. This means the corporation is taxed twice.
Corporations can apply deductions and losses to their taxable income; however, shareholders cannot.
Taxes applied to corporations vary from state to state. So if this option is appealing to you, we suggest doing a bit of more research on the applicable tax laws or speak with one of our accountants.
Why would anyone be interested in forming a corporation?
- Liability is limited since the corporate entity is separate from its shareholders.
- Easier to raise capital since investors are more likely to make more money.
- Quicker Investor Return - This differs from other structures where investors return may be at a much slower rate.
- Can last much longer since operations are not based on a single owner.
If an owner dies or decides to leave, the corporation can maintain operations without having to restructure the business.
- Owners are not legally liable over the corporation’s actions.
- Stock can be sold to help raise more capital.
- Investors are more likely to obtain their return faster.
- It can be an expensive and lengthy process with lots of regulations, such as the issuance of financial statements.
- There is the possibility of double taxation on profits, first to the corporation and then to the shareholder.
Corporations are best formed by large businesses that can take on the expenses and hassle of filing.
There is also the possibility of double taxation which can be a nail in the coffin for companies with low profits.
If you are considering filing as a corporation, we suggest you speak with your CPA about the process before continuing.
4. S Corporations
S Corporations are similar to Corporations with a few added benefits.
S Corporation income, losses, deductions, and credits are carried onto the shareholders who report it on their returns. This prevents the issue of double taxation.
You may be asking, why doesn’t everyone just become an S Corporation instead of a Corporation?
Unfortunately, it is a bit more challenging than checking a box.
There are many requirements to be considered an S Corporation. Even then, there are additional forms that must be submitted.
- Like Corporations, S Corporation owners are not legally liable for the business, and the business will have an easier time financing operations.
- Also, an S Corporation can benefit from pass-through taxation.
- It can be expensive and time-consuming to keep and maintain S Corporation status.
- S Corporations must also be owned by U.S. citizen’s, limited to 100 shareholders, and subject to closer watch by the IRS.
S Corporation status is ideal for those who can take on the expenses and hassle of filing as an S Corporation.
Also, there are additional requirements to become an S Corporation over a general corporation.
We suggest talking with your CPA to see if your business is eligible.
5. Limited Liability Company (LLC)
Limited Liability Companies may be similar in structure to S Corporations, but they are regulated differently from state to state.
Check with your state to understand the regulations that may apply to you.
Owners of LLC’s are referred to as members, and there is no maximum number of members. Most states even allow one member LLCs.
How an LLC is taxed can be a bit complicated, since they can be taxed as a corporation, partnership, or as a disregarded entity.
If an LLC has multiple members, it can be considered a partnership. If there is only one, it is likely taxed as a separate entity from its single member.
Understanding the regulations and tax implications of becoming an LLC can vary from state to state and business to business.
For this reason, we suggest talking with your CPA to understand more about how becoming an LLC can affect your business.
- In an LLC the members are protected from business liability, no matter how it is taxed.
- They are easier to form than some other business structures, and there are some flexible tax options.
- While it is easier to form, there will still be some startup and annual costs.
- It can also be a bit difficult depending upon your state’s unique requirements.
If you are worried about potential liability an LLC can be a good option.
As long as you fit within the requirements of your state, are confident in the applicable tax structure, and can handle some of the costs associated with filing.
This publication is designed to provide information of federal tax and accounting laws and/or regulations. It is presented with the understanding that the author is not rendering legal or accounting services.
This text is not intended to address every situation that arises or provide specific, strategic tax and/or accounting planning advice. This text should not be used solely to answer tax and/or accounting questions and you should consult additional sources of information, as needed, to determine the solution to tax and/or accounting questions.
This text has been prepared with due diligence. However, the possibility of mechanical or human error does exist and the author accepts no responsibility or liability regarding this material and its use. This text is not intended or written by the practitioner to be used and cannot be used by a taxpayer or tax return preparer, for the purpose of avoiding penalties that may be imposed.