Does the thought of incorporating or deciding on a business structure seem daunting, and maybe a little unnecessary, for your small business?
You may be stuck trying to figure out which business structure is right for your business. Should you just stick with the status quo and choose a sole proprietorship or partnership?
Picking a business structure is usually the first big legal and tax decision for a new business owner—and one of the most confusing ones you’ll make.
Please keep in mind that (as 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.
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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. Each legal structure comes with different guidelines to follow, levels of liability protection, and tax requirements.
The following definitions are sourced from Investopedia:
C corporations (C corps) are legally considered separate entities from their owner. Income is taxed at the corporate level and is taxed again when it is distributed to owners.
An S corporation (S corp) gives a corporation with 100 shareholders or less the benefit of incorporation while being taxed as a pass-through entity. Therefore, the Internal Revenue Service (IRS) doesn’t tax profits earned by the corporation at the corporate level, but rather on the personal tax returns of the individual shareholders.
LIMITED LIABILITY COMPANY
As the name implies, a limited liability company (LLC) is a corporate structure where the members of the company have limited liability protection from the company’s debts and liabilities.
Limited liability companies are also pass-through entities, so the business doesn’t pay taxes. Members pay taxes on their share of company profits on their personal tax returns.
A partnership is an arrangement in which two or more individuals share the profits of a business venture. Partners in this tax structure also hold unlimited personal liability for any debts the business incurs. Partnership business structures are also pass-through entities for tax purposes.
A sole proprietorship is an unincorporated business entity with one owner (the sole proprietor) who pays personal income tax on profits from the business. With little government regulation, sole proprietorships are the simplest business to set up or take apart. They also give you complete control over your business and its day-to-day operations. This makes a sole proprietorship business structure popular among independent contractors and owners of very small businesses. However, sole proprietorships are not considered a separate business entity from their owners.
Here are a series of questions that cover the key differences between these major business structures in the U.S. Your answers can help you choose a business structure that works best for you and your situation.
1. Are You Concerned About Personal Liability?
If you work in a high-risk field or one that’s susceptible to lawsuits (like medicine, food, tattoos, daycare, dog-sitting), this is a no-brainer. You’ll want a business structure that comes with limited personal liability.
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 are put at risk in these situations because of the unlimited personal liability of these business structures.
Forming a corporation or LLC will provide business owners with liability protection, as each business structure puts some separation between your personal assets and your business. Should your business get sued, these business structures can protect your personal assets in many situations.
2. Will You Hire Employees or Contractors?
An official business structure, meaning a limited liability company 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. Sole proprietors and general partnerships, on the other hand, don’t have that protection and will be personally liable for their business’s debts.
If you hire people or are planning on hiring people, then forming a corporation or limited liability company is probably a good safeguard for you.
3. Do You Like to Keep Things Simple?
While corporations and limited liability companies both give you personal liability protection, these business structures differ in terms of formality and paperwork.
If you’re a solo professional or service provider operating as a sole proprietor, then you’re very familiar with self-employment taxes. These are 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.
This is where it gets interesting. 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-U.S. Residents?
In order to form an S corporation, all owners must be U.S. residents. Non-residents can form C corporations and limited liability companies. Therefore, if you are a non-resident and want to pass-through the profits to your personal taxes (as described above), you’ll need to form a limited liability company.
7. Do You Want to Offer Employee Benefits?
Compared to other business structures, 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’s 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 corporate structure.
In addition, most venture capital investors prefer to invest in corporations more than any other business structure; this is because the corporation structure lets you create different classes of stock.
There are some other factors to consider when choosing between the types of business structures available, but these questions highlight the main differences between each one and should serve as a good introduction to the business structure that is right for you.
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This post was updated in December 2021.