Does the thought of incorporating seem daunting, and maybe a little unnecessary, for your small business? Are you stuck trying to figure out which business structure is right for your business? Should you just stay with the status quo (sole proprietor/partnership)?
Picking a business structure is usually the first big legal decision for a new business owner and one of the most confusing. Please keep in mind that (like with anything you read online) this is general business advice and shouldn’t replace the advice of an attorney, accountant, or tax advisor who is familiar with your specific situation. In addition, this information is geared toward U.S. companies.
An Overview of Different Business Structures
Before we go any further in the article, I’d like to take a moment to define the different types of business structures. The following definitions are sourced from Investopedia:
C Corporation: Legally considered separate entities from their owners… Income is taxed at the corporate level and is taxed again when it is distributed to owners.
S Corporation: This gives a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a partnership. This means that any profits earned by the corporation are not taxed at the corporate level, but rather at the level of the shareholders.
Limited Liability Company (LLC): A corporate structure where the members of the company cannot be held personally liable for the company’s debts or liabilities.
Partnership: An arrangement in which two or more individuals share the profits and liabilities of a business venture.
Sole Proprietorship: An unincorporated business with one owner who pays personal income tax on profits from the business. With little government regulation, they are the simplest business to set up or take apart, making them popular among individual self contractors or business owners.
Here are a series of questions that cover the key differences between the major business structures in the U.S.: C Corporation, S Corporation, Limited Liability Company (LLC), Partnership, and Sole Proprietorship. Your answers can help you figure out which structure is best for you and your business.
1. Are You Concerned About Liability?
If you’re working in a high risk field or one that’s susceptible to lawsuits (like medicine, food, tattoos, daycare, dog-sitting), this is a no-brainer. But no matter what your business type, you should seriously consider if there’s a chance your business could be sued or won’t be able to pay its debts. If you’re operating as a sole proprietorship or general partnership, your personal assets (home, car, savings) are put at risk in these situations.
Forming a corporation or LLC puts some separation between your personal assets and your business; these structures can protect your personal assets in many situations should your business be sued.
2. Will You Hire Employees or Contractors?
An official business structure, meaning an LLC or corporation, can protect you personally from the actions of your employees. If you hire someone (an employee or contractor) and they make a mistake that results in damages, the “corporate shield” of a corporation or LLC can minimize your personal liability. If you hire people, or are planning on hiring people, then forming a corporation or LLC is probably a good safeguard for you.
3. Do You Like to Keep Things Simple?
While corporations and LLCs both give you personal liability protection, they differ in terms of formality and paperwork. A corporation is more complex to run and manage: you need to appoint a board of directors, hold an annual shareholders’ meeting and directors’ meetings, document key shareholder and director decisions, and file a separate corporate income tax return. For an LLC, you typically just need to file an Annual Report with the state.
If you prefer to minimize your paperwork and legal obligations, the LLC is a better choice than a corporation. Of course, the sole proprietorship/general partnership involves the least amount of formalities, but these structures don’t give you any liability protection.
4. Do You Want “Pass-Through” Tax Treatment?
A C Corporation needs to file its own corporate tax return. This means that a corporation pays income tax on any profits it makes for the year. In some cases, this can hurt a small business owner because of “double taxation.” In cases of double taxation, the company pays income taxes on its profits, and then if the business owner takes those profits out of the business (e.g. in dividend distributions), the owner needs to pay taxes again on his or her personal tax return.
By contrast, the S Corporation and LLC are considered “disregarded entities” for tax purposes – which is legalese for saying that these companies don’t pay corporate taxes on the profits. Instead, all profits are passed along to the business owner(s) and reported on their personal tax return. Depending on your situation, this could make tax reporting much simpler and result in lower taxes overall (talk to a tax advisor/accountant for specific tax advice).
5. Are You Looking to Lower Your Self-Employment Taxes?
If you’re a solo professional or service provider operating as a sole proprietor, then you’re very familiar with self-employment taxes, the self-employed person’s version of the FICA tax. If you form a C Corporation or S Corporation, then you pay yourself a salary for the work you do – and you pay FICA tax, not self-employment tax on this salary.
Where things get interesting is that if your business makes additional profits after your salary, you can distribute those extra profits to yourself as a distribution and you don’t pay FICA or self-employment tax on it. This is a good topic to discuss with your tax advisor or accountant.
6. Are Any of the Business Owners Non-US Residents?
In order to form an S Corporation, all owners must be U.S. residents. Non-residents can form C corporations and LLCs. If you are a non-resident and want to pass-through the profits to your personal taxes (as described above), then you’ll need to form an LLC.
7. Do You Want to Offer Employee Benefits?
A corporation gives you the most opportunities to offer employee benefits like health plans, medical reimbursement plans, contributions to retirement plans, contributions to life insurance plans and these expenses are deducted from the business’ taxable income. You can talk to a CPA or financial advisor to figure out how to set up these types of benefits.
8. Do You Want to Give Employees or Others Stock in Your Company?
If you have any interest in giving stock benefits and stock options to employees, investors, partners, and others, you’ll need to form a corporation. In addition, most venture capital investors prefer to invest in corporations rather than any other business structure; this is because the corporation lets you create different classes of stock.
There are some other factors to consider when choosing a business structure, but these questions highlight the main differences and should serve as a good introduction to helping you select which structure is right for you. If you have any questions, feel free to ask them in the comments.
About the Author: Nellie Akalp is a passionate entrepreneur, small business expert, professional speaker, author and mother of four. She is the Founder and CEO of CorpNet.com, an online legal document filing service and recognized Inc.5000 company. At CorpNet, Nellie assists entrepreneurs across all 50 states to start a business, incorporate, form an LLC, and apply for trademarks. She also offers free business compliance tools for any entrepreneur to utilize. Connect with Nellie on LinkedIn.