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Congratulations on making the decision to start a new business! You’re joining more than 30 million other small business owners operating in the US today. But before you pass Go and collect $200, your first big decision is to determine the best legal business structure to use for your small business.
There are several types of entities that can be a good fit for small businesses, but each choice has an impact on how you’re taxed, your level of personal liability, and your ability to hire and fundraise. Bottom line, someone who’s thinking about founding the next unicorn tech company might want to approach things a little differently than someone who’s starting a medical practice or restaurant Choosing a business structure means looking closely at how you want to operate your business, then finding the entity type with the right benefits and legal protections. Here’s a close look at the options available, plus some guidance to help you make the right decision.
What is a business entity?
A business entity is the legal organization under which you run your business. Often, entities are used to separate the obligations and responsibilities of a business from the people who own it, for the purpose of protecting business owners from the liabilities of the business, simplifying accounting, and making it easier to transfer ownership of the business.
The most common for-profit business types are sole proprietorships, partnerships, LLCs, S Corporations and C Corporations. Check out a quick overview of the different structures, then read on to get help making a decision about which entity you should choose.
How to decide which one makes sense for your business
The first decision you’ll need to make is whether or not you want to incorporate your business. Incorporating your business helps limit personal liability and gives you options on how your business profits will be taxed, but it is also a more formal process requiring applications/articles of incorporations with states and associated fees.
If you decide not to incorporate
Your entity type will be determined based on whether your business is made up of just you or two or more individuals. While there is no formal application process to be considered a sole proprietorship, there are certification requirements for creating certain types of partnerships. Without incorporating, you’ll risk your personal assets being used to pay business creditors.
|Entity type||Who owns the business?||Who has liability||Who pays the taxes?||Key things to consider|
|Sole Proprietorship||Sole proprietor (1 individual)||Unlimited personal liability||Sole proprietor is taxed at their personal rate||Income is reported on personal tax return|
|Partnership||Partners (minimum 2 or more)||Unlimited personal liability unless structured as a limited partnership||Each partner is taxed at their personal rate||Self-employment taxes
The various types of partnerships (e.g. LLP and LP)
If you choose to incorporate your business
You’ll need to decide how you want the business to be taxed. Incorporation requires annual fees, articles of incorporation, and separating business finances from personal finances.
|Entity type||Who owns the business?||Who has liability?||Who pays the taxes?||Key things to consider|
|Limited Liability Company (LLC)||Members (1 or more)||Owners are not personally liable||Two options:
Members as pass-through or as a C corp
Single-member LLC is considered a disregarded entity
|S Corp||Shareholders (1 – 100)||Owners are not personally liable||Shareholders – taxed as salary and as income pass through||Taxation may vary by state|
|C Corp||Shareholders (1 or more)||Owners are not personally liable||The corporation at the corporate tax rates. – Shareholders may receive dividends which are also taxed||Double-taxation|
Let’s break down all the options in more detail.
By far the simplest business structure, a sole proprietorship is a common choice for businesses with a single owner, low risk of liability, and no immediate intention to add a partner or employees. There are no formal steps you need to take to set up a sole proprietorship. Tax-wise, a sole proprietorship allows you to report your income on your personal tax return using Schedule C, which you would complete and file along with your 1040. Your business losses, if any, can also help to offset taxes on any other income you or your spouse may earn.
While convenient, a sole proprietorship does require specific forms and regular tax payments to the IRS. You’ll need to file self-employment tax using a Schedule SE annually. In addition, if you expect to owe taxes, you may need to make quarterly tax payments to the IRS.
Perhaps most importantly, sole proprietors remain personally responsible for any company liabilities, making personal assets such as your home vulnerable for business debts, lawsuits, or other potential liabilities. Also, keep in mind that you may find it challenging to raise money from outside sources as a solo operator.
If you have chosen to go into business with others, a partnership structure may be a good fit for your business. There are two types to choose from: a general partnership and a limited partnership.
A general partnership works a lot like a sole proprietorship, except that there are two or more business owners. Like sole proprietors, all general partners actively manage the business, their share of the partnership’s income is taxed at each partner’s personal income tax rate, and they personally assume responsibility for all business liabilities. General partners are also responsible for paying self-employment taxes.
In a limited partnership, there are two types of partners: general partners (as described above) and limited partners who do not play an active role in running the business. These limited partners are typically investors, and they are not subject to personal liability for the actions of the business. Like general partners, they report profits and losses from the business as ordinary income, but they are not required to pay any self-employment taxes because they don’t work for the business.
Note that not all businesses can register as an LLP — most often they are law, accounting, architectural, or other professional services firms. You’ll want to do some research about what your state allows since some states are stricter than others when it comes to partner liability. Partnerships are required to file Form 1065 annually, while all partners report their individual income or losses using a Schedule K-1. It’s a very good idea to have a partnership agreement in place that clearly outlines the purpose of the partnership, and the roles, responsibilities, and ownership interests of each partner.
Limited Liability Company
Limited liability companies, referred to as LLCs, have the benefits of both a partnership or sole proprietorship and a corporation. As the name implies, LLCs offer protection from personal liability for the activities of the business.
That’s the good news. The bad news (and it’s not that bad) is that setting up an LLC requires jumping through a few small hoops, like filing articles of incorporation (or articles of organization in some states) and paying annual fees. You can find instructions and any additional requirements through your state’s Secretary of State. If you’re hiring employees, you’ll also need to set up an Employer Identification Number (EIN).
By default, the business owner (and any other partners in the LLC, who are called “members”) pass through profits from the LLC to themselves and pay their personal income tax rate. They can also be on the hook for self-employment taxes if they’re involved with the day-to-day running of the business. However, LLCs also have the option of being taxed at the corporate tax rate by filing an entity classification election (Form 8832) with the IRS.
The biggest difference between an LLC and S Corp is how it is taxed. An S Corp is a type of corporation that’s designed to avoid the double taxation of regular C corps. S Corps allow profits, and some losses, to be passed through directly to owners’ personal income without ever being subject to corporate tax rates.
Let’s start with the formalities. An S Corp is a true corporation, and the owners are viewed as shareholders. That means an S Corp must have articles of incorporation like an LLC as well as a board of directors, corporate minutes, and a requirement to put all agreements in writing. If these formalities aren’t maintained, you run the risk of losing liability protection. S Corps must file with the IRS to get their status — a different process from registering with their state.
As a corporation, that also means owners don’t pay themselves through an owners’ draw like a sole proprietor or most LLCs would. Instead, any owners who actively work for the business pay themselves a salary that would be taxed at their personal rate — and FICA and FUTA payroll taxes apply. Additionally, any profits from the business can be distributed to shareholders in the form of dividends. For some business owners, the tax rate on dividends may be lower than their personal tax rate, hence the potential tax savings.
It’s a good idea to talk to an attorney and tax professional to understand whether you should structure your business as an LLC or S Corp if your primary motivation is tax savings.
S Corps are also sometimes referred to as “small corporations” because there’s a limit of 100 shareholders who must be US citizens. That limit wouldn’t be an issue for most small businesses but might be if you plan to offer employee equity, seek financing from a large number of investors, or grow a lot. Similarly, S-Corps can only have one class of stock, so if you wanted to (for example) have voting and non-voting shareholders, you would need to choose a C Corp.
C Corporations are by far the most comprehensive and complex business structure. As a separate legal entity, C Corporations provide you with the most protection for your own personal assets. In addition, as a C Corp, your business is able to retain some of the profits earned without being taxed — but there are limits. If you expect your business to grow in the coming years, a C Corporate structure may be your best bet, particularly if you’re looking to raise funds from investors.
The downside to using a C Corp structure is double taxation since you’ll not only be paying corporate taxes on your income but also on any distributed earnings as well. There are ways to lessen your tax burden, so talk to your accountant to find out more.
What if my business changes or I change my mind?
Changing your business structure isn’t easy: You’ll probably need to consult an accountant or lawyer, and there may be restrictions based on your location — but it can be done. With the exception of a sole proprietorship, changes to all other business entity types will require you to file legal documents in the state where you’ll be doing business. So, if your business evolves or you feel that a different structure is a better fit, there’s probably some paperwork in your future. There are also limits on how often you can change the structure type.
For example, in a partnership, you’ll have to file a partnership agreement, while S corporations and corporations require you to file articles of incorporation. If you’re considering an LLC, you’ll need to file articles of organization in your state.
Choosing a business structure is the first step towards building a successful future. Whatever option feels right to you, be sure to consult with a legal or tax professional who can guide you toward the business structure that will work best for your business. You may also find some helpful information at the IRS website or SBA website.
This information is not to be taken as tax, legal, or financial advice. Please consult a lawyer, accountant, or business planning expert for specific guidance for your business.