Which business structure is the best for my business?
There are a variety of factors that you should consider before deciding which business structure is the best fit for your business and personal needs. As part of your planning process, consider the following:
- What is your end goal for your business? (do you plan to keep it forever, build it and pass it along to family, or to sell it at some point?)
- What are your goals related to income and financial strategy? Do you want to maximize earnings and profit to position your company for expansion and a future sale? Do you want the greatest tax protection available?
- What level of support suits you? Will you have a team in place from the beginning to support your business in all that is required for management of the tax and legal requirements of operating an s-corp or a c-corp? Do you prefer to do most of the work and the document management and book-keeping yourself or with minimal help (and so prefer a sole-proprietorship or LLC)? What is your preferred level of involvement and realistically what are you able or wanting to do when it comes to managing all of the paperwork aspects of your business?
- What level of risk are you willing to take on? (Sole proprietorships offer no separate business protection, whereas LLCs and S-corps and C-corps do, when created and managed properly).
- What level of complexity do you want at formation? Some entities are simply easier to form than others.
The most common business structures are sole proprietorships, general partnerships, limited liability companies (LLCs), “C” (regular) corporations, and S-Corporations. Let’s review a quick summary of each of these.
A sole proprietorship is an unincorporated business owned and run by one individual with no distinction made between the individual and the business. As a sole proprietor, you are responsible for all debts, losses and liabilities of your business, and you are personally taxed on all business income. Sole proprietorships require no official formation documents, but may still require a business license depending on your location, along with a registration of your “dba” (doing business as), trade name, or fictitious business name.
Limited Liability Company
Limited liability companies combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. Limited liability companies are not corporations and are not required to abide by the same formalities, although they share the limited liability protection. Like partnerships or sole proprietorships, LLCs are more flexible, less formal, and are treated by default as a pass-through entity where members report the income or loss on their individual tax return.
For single member LLCs, the company is treated by default as a disregarded entity for tax purposes. For LLCs with multiple members, the default tax status is as a general partnership. LLCs with both single or multiple members can elect to be treated as an s-corporation or a C-corporation.
LLCs are the most widely used business structure in the United States and provide a great deal of flexibility in the way that they are managed and treated for tax purposes.
In some states, professionals who are required to be licensed in order to provide services in their state (doctors, lawyers, accountants, architects, engineers, etc), are required to set up a Professional Limited Liability Company instead of an LLC. PLLCs often have additional restrictions, requiring all members to be licensed practitioners of the same profession. They are also not afforded the same protection from personal liability in regards to professional malpractice claims.
A general partnership must have two or more people engaged in business for profit. It can be created formally (by agreement) or informally, by association, proof of existence, or estoppel, and, like sole proprietorships, makes no distinction between the business and the individuals. The individuals are each jointly and severally liable for all debts, losses and liabilities of the business.
By default, partners share equally in the profits; however, as with other business forms, a partnership agreement may expressly provide for the manner in which profits and losses are to be distributed.
Each partner is an agent of the business, and may conduct business and enter into agreements on behalf of the business (and other partners).
Partnership agreements typically will outline how new members may be added to the partnership, usually by unanimous consent of all other partners, as well as events that would cause the termination of the partnership, including the death, disability or withdrawal of a member.
A corporation is an independent legal entity owned by shareholders whose liability is limited to their investment. The corporation itself, and not the shareholders, is held legally liable for the actions and debts of the business.
Corporations are subject to greater formalities by way of management and paperwork than other entities, making them a more expensive and less desirable option for small businesses. But because of a corporation’s ability to raise capital through public offerings, this structure is desirable for larger companies with many employees, larger growth trajectories, and the ability to absorb the cost of doing business as a corporation.
Corporations file taxes separately from their owners, which means that despite the advantages of a corporate tax rate, corporations may be taxed twice, first at the corporate level when the company earns a profit, and again when dividends are paid to shareholders.
S-Corporations are created through a special tax election, in which the owners of a valid corporation or LLC elect to be taxed under SubChapter S of Chapter 1 of the Internal Revenue Code. This election allows business owners to avoid the double taxation of C Corporations by allowing the profits and losses to pass through to the individual shareholders for federal tax purposes.
This is an election that is also available to and frequently taken by LLCs. From a legal perspective the company remains a limited liability company, but from a tax perspective, it is treated as an S-Corp. This allows the LLC to pay its members who work for the company “wages” as compensation for services rendered and distribute the rest as shareholder distributions, which allows some tax advantages.
An important requirement of the IRS, however, is that any shareholder who works for the S-Corporation must pay him or herself “reasonable compensation” and so a review of S-corporation tax filings may result in the IRS determining that a larger amount must be paid in wages.
With the help of an attorney, or a qualified CPA, you will be better prepared to sort through the various options available to you, and select a business structure that is the best fit based on your business, your goals, and other factors including personal needs and desired level of involvement in the management of your business.
For more information on Business Formation see the following articles….
DISCLAIMER: THE INFORMATION PROVIDED IN THIS POST MAY CONTAIN LEGAL INFORMATION, BUT DOES NOT CONSTITUTE LEGAL ADVICE. NO RELATIONSHIP, INCLUDING ATTORNEY-CLIENT RELATIONSHIP, HAS BEEN FORMED AS A RESULT OF THIS POST. YOU ARE ADVISED TO SEEK THE ADVICE OF AN ATTORNEY LICENSED IN YOUR STATE IF YOU HAVE ANY QUESTIONS.