If you are starting your own business, you must decide what form of business structure (also called legal entity or business formation) you want to establish. Choosing the best business structure for your company requires some time and careful consideration. Your choice will affect several areas: your level of participation and control, your grade of liability, and even the way you pay taxes. Have in mind that there is no “one size fits all” business structure, and each comes with its own pros and cons.
The three most popular legal formations for small businesses are:
- Sole Proprietorship
- Limited Liability Corporation (LLC)
The key is to figure out which structure gives your business the most advantages to help you achieve your organizational and personal financial goals. When choosing the most appropriate entity type for a business, you should consider the following factors:
- the potential risks and liabilities of your business
- the formalities and expenses involved in establishing and maintaining the various business structures
- your income tax situation
- your investment needs
Also, keep in mind that your business is not locked down to a certain entity type forever. You can opt to change the business structure of your company over time. In many cases, businesses initially start as a sole proprietorship with lower start-up costs, and eventually opt-in for more sophisticated structures that protect personal assets from business liabilities and/or enable individuals to invest in the company. The following article touches on the pros and cons of the most popular small business legal formations.
This is the simplest form of business structure. If you’re the sole owner of your business and never legally formed the company, you’re running a sole proprietorship. Even if you filed a fictitious business name (know as a DBA, that stands for “Doing Business As”) in your county or state, you’re still a sole proprietorship. There is no legal difference between you and your company. Meaning, you’re completely liable as a sole proprietor for any activities related to your business. Also, any credit you obtain under the DBA is technically made to you and not a separate legal entity (i.e. you’re not building a business credit history, only personal credit).
Learn here everything you need to know about a DBA
This type of business structure is ideal for those who want to be their own boss or run a business from home without a physical storefront. A sole proprietorship allows the owner to be in complete control.
- Pros: There are hardly any start-up costs and tax preparation is easy. You are responsible for all the profits (you don’t have to share!)
- Cons: It’s harder for you to raise capital for your business. You are responsible for all the debts. You have unlimited personal liability, meaning there’s no separation or protection of personal and professional assets, which could prove to become an issue later on as your business grows and more aspects hold you liable.
Limited Liability Corporation
A limited liability company is a hybrid structure between sole proprietorship and corporation (next section).
Unlike a sole proprietorship, LLCs provide members with personal asset protection against the company’s debts and other business-related obligations. This means that LLC members are not risking their homes and other personal assets when operating the business. BUT, there is still risk you can be held personally liable in the case of a lawsuit filed against your business. The trade-off here is forming an LLC comes with higher start-up costs. You need to file formation documents including Articles of Organization. Also depending on the state, each LLC needs to pay annual fees that vary widely by state (the annual tax fee in CA is $800). From a tax perspective, an LLC is considered a pass-through entity which means business profits or losses are taxed on the owner(s)’s personal tax return. If the LLC has only one owner, the business tax return is filed in Schedule C of the individual tax return (exactly the same as a sole proprietorship). Lastly on taxes, if the owner of an LLC is considered to be self-employed, you must pay the 15.3% self-employment tax contributions towards Medicare and social security. As such, the entire net income of the LLC is subject to this tax.
- Pros: company offers more protections and separations to businesses than sole proprietorships. Your profits and losses are not taxed at the corporate level (preparing a tax return is as easy as in a sole proprietorship).
- Cons: Higher start-up costs than a sole proprietorship.
The law regards a corporation as a separate entity from its owners. Therefore, the owners are not held responsible for any financial hardships or lawsuits filed against the business. A corporation has its own legal rights, independent of its owners – it can sue, be sued, own and sell properties, and sell the rights of ownership in the form of stocks. Different from an LLC, the start-up and ongoing costs (and labor) in a corporation are higher. Have in mind that corporations are required to adopt bylaws, issue stock, hold initial and annual director and shareholder meetings, and keep meeting minutes with corporate records. In other words, this business structure is more complicated and expensive than an LLC, but the profits it generates can also be higher.
This business structure is ideal for businesses that have been around for a while and are expecting to grow exponentially, or businesses with shareholders.
Now, when it comes to paying taxes, you must be aware that there are 2 types of corporations, and taxation works differently for each:
C corporation: it’s treated as a separate taxable entity by the IRS. A C corporation is taxed at the corporate tax level, and at the personal tax level when payments are made to the shareholders. This is what is called “double taxation.”
S corporation: to avoid double taxation, in an S corporation the income and losses of the company are divided between the shareholders and pass through to their personal income taxes. Therefore, the S corporation is not taxed at the corporate level, but only the shareholders are taxed at the individual level.
To sum up,
- Pros: shareholders of a corporation are not liable for any debts incurred or judgments handed down against the corporation. Corporations may be able raise additional funds by selling shares in the corporation.
- Cons: Higher level of complexity, and higher costs. Complexity when it comes to fill in taxes.
We hope this post has shed some light about what type of business structure you should pick for your company. Need more information? Check this post with the differences between Sole Proprietorship, LLC and Corporation.
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