Before you start your own business, there’s a requirement you need to comply: you have to decide the legal formation you want for your business. This is also called “business structure” and “legal structure”. It’s a requirement by law. The good news is you don’t need to be a lawyer to make a decision on your legal formation. It can take more or less time, and cost more or less money depending on the structure of your choice. Each of them has different features, pros, and cons. Which one will be the best fit for your business? Before you answer that question, you must get familiar with the following terms: DBA, Sole Proprietorship, LLC, and Corporation. In other words, the different types of legal structures. Picking the right structure for your business will allow you to manage three important elements: liability, taxes, and complexity. Have in mind that each of the legal formations we will explain in this article take very different approaches to taxation.
By default, unless you file otherwise, your business will be structured as a sole proprietorship, which means that there is one owner. This is the simplest business structure to form. If your business is a sole proprietorship, probably you’re already familiar with the term DBA. What is it exactly? DBA is an acronym for, “Doing Business As” and refers to there being a difference between the legal name of the business and the name by which it operates day-to-day – the name by which customers and associates may know the company (the DBA). Some states do require businesses to register the DBA name before they can begin using it, such as California and Florida.
A DBA is not a legal structure (the legal structure is the sole proprietorship), but rather a way to allow a sole proprietorship to have a business name without having to file an LLC or Corporation. While simple and inexpensive, it comes with the same risk as being a sole proprietorship or general partnership.
Now, let’s review in detail each of the legal formations you can choose for your business: Sole Proprietorship, Corporation, and LLC.
What is a Sole Proprietorship?
Again, a DBA is a title assigned to sole proprietorships. Sole proprietorships have only one owner and they are the simplest way by which to operate a business. If you are self-employed, or, as previously mentioned, not yet determined a business structure, then this is your default.
The biggest advantage to operating a sole proprietorship is that it is very simple to form and maintain. And, since there isn’t a delineation between the business and the owner, it means that any income earned by the business is earned by the owner, so no separate taxes need to be filed. One would simply need to keep track of monies earned and file the Schedule C with the personal tax returns.
A sole proprietorship means there is not any separation between the business owner and the business. What does this mean, exactly? Essentially, it means that if someone sues your business or if your small business defaults on any loans, your personal assets (home, cars, personal bank accounts), can be on the hook. This is why the Limited Liability Corporation (LLC) and the C Corporation (or, simply Corporation) are popular business structures, as they limit the personal liability of the owner.
Before we continue with the other legal formations, you may want to learn the difference between sole proprietorship and partnership, and if it is time for you to convert your sole proprietorship to another type of legal formation. And if you are ready to apply for your DBA and you want to do it the easiest way, learn here how to set up a DBA using LegalZoom.
What is a Corporation?
A corporation is considered a separate entity from its owners, therefore, the owners will not be held responsible for any financial hardships or lawsuits filed against the business. This protection is often called a “corporate shield”, as it shields the owners’ assets.
This business structure is often seen as overly administrative for the average small business. The reason being that this entity requires a formal structure of shareholders, directors, officers, and employees. Each corporation is required to appoint at least one person to serve on the board and the officers are required to oversee the day-to-day operations of the business. This is generally only a good option for a small business that has been around for a while and is preparing to go public or grow significantly.
For tax purposes, a Corporation files its own taxes, separate from those of the owner. As such, if you are the owner of a corporation, you will need to file both your personal taxes and taxes for your small business. In turn, this can result in, “double taxation”, which means that the business pays taxes on any profits and the owner pays taxes on those profits after they have been distributed to them.
It may be seen as though from a taxation standpoint, a C Corporation is not the way to go, and in many cases, that may be true. However, one thing to consider, especially if you are intent on growing your business significantly and therefore investing profits back into the company, is that a C Corporation only pays taxes on those profits that are distributed to their shareholders. Meanwhile, members or owners of an LLC, an S Corporation (both of which will be addressed shortly) and a sole proprietorship pay taxes on any profits, whether they are deposited into personal bank accounts or invested back into the business. Also, remember the corporate shiel mentioned above. You won’t be held responsible if your business falls into legal trouble.
What is an S Corporation?
If you opt to be legally formed as a Corporation, there are to types: a C Corporation (explained above) and an S Corporation. To sidestep this double tax burden, some small business owners will form an S Corporation. This means that the business does not file its own taxes, but rather profits are passed through and filed on the individual taxes of the shareholders. If any of the shareholders are employees of the company, then the business must pay a fair wage to those employees, aside from their profit shares, and payroll taxes on the aforementioned wages. Additionally, it is important to keep in mind that not all C Corporations will qualify for S Corporation status. For example, an S Corporation cannot have more than 100 shareholders and they must all reside in the United States.
What is an LLC?
An LLC is essentially a hybrid of a C Corporation and a sole proprietorship.
There is a reason as to why this is generally the most popular business structure among small businesses. Much like a corporation, it protects the personal assets of the owner, without requiring the same level of administrative oversight or paperwork to file. Additionally, you have more flexibility with an LLC as to how you are taxed: you can choose to either be taxed as a C Corporation, where the business files taxes separately, or as an S Corporation, where the profits are passed through to the owner, who then reports them on their personal taxes.
Every state has its own laws regarding the formation of an LLC, however, unlike requirements for establishing a DBA, no state requires a business to form an LLC. Rather, it is completely voluntary and is a choice made by the business owner regarding whether or not it’s a solid decision for them.
If you (and, if applicable business partners) own an LLC, then you are not considered employees, but members. As such, you do not have to pay Social Security or Medicare taxes on your profits. However, if you actively work in the business and earn a salary, then you will need to pay self-employment taxes on that income. However, with a corporation, only salaries are subject to taxation, profit sharing is not.
If your small business employs paid staff and you are committed to offering competitive benefits, then this is another area in which you will want to carefully weigh the differences between an LLC and a Corporation. There are some benefits such as retirement plans that are only available to corporations, while an LLC will be expected to pay taxes on certain benefits, such as health and life insurance.
Still confused? Get Assistance!
Just as every small business is different, so will the best option for said businesses. And, yes, as your company grows and changes, you can change the business structure. Consulting a respected, trustworthy tax attorney or business advisor is a good first step in determining which business structure will be the best option for you.
If you’re still struggling to understand the difference between DBA, LLC, and Corporation, Camino Financial is more than happy to assist you in setting up your business. Simply call us at (800) 852-0655 and we’ll get you set up right away. And if you want to stay on top of the latest trends and news in business, simply subscribe to our Newsletter. It’s free and every week you’ll receive useful information like the one in this article and tips to grow your business.