Selecting the legal structure for your business is one of the most important decisions you will make as a small business owner. Your business structure will define your company’s legal structure, tax obligations, and compliance requirements. It will also have a significant impact on your personal liability as it relates to your business.
A structure that worked well in the early years of your business may not meet your needs as you expand or seek potential investors. Changing your business structure can help lower your tax liability, protect your personal assets, and plan for the future.
Small business owners have several choices when deciding on a business entity. According to the IRS, there are five business structures to choose from:
- Sole Proprietorships
- C Corporations
- S Corporations
- Limited Liability Company (LLC)
Pros and Cons of Each Business Structure
There are advantages and drawbacks to each type of business structure. Selecting the right one can be a complicated process. Here are some key points to consider for each type of business structure:
1. Sole Proprietorships
Sole proprietorships are the easiest type of business to start and to understand. As a sole proprietor, you’re the only person to own and operate the business. Service professionals, freelancers, and consultants often operate as sole proprietors.
The biggest benefit of sole proprietorships is that they’re easy to start and you don’t have to deal with complicated paperwork. Filing taxes is easier and a large portion of your business losses can be deducted from your personal tax return.
A big drawback with sole proprietorships is that you and your business are one entity. So if someone seeks legal action against your business, your personal assets could be at risk.
Partnerships are the simplest structure for two or more people to own a business together. There are three common types of partnerships: general partnerships, limited partnerships (LP), and limited liability partnerships (LLP).
- General partnerships involve two or more owners who share equal rights and responsibilities in connection with the management of the business. Any individual partner can bind the entire group to a legal obligation. Each individual partner assumes full responsibility for all of the business’s debts and obligations.
The personal liability is significant but it comes with a tax advantage - partnership profits are not taxed against the business but pass through to the partners, who include the gains on their individual tax returns at a lower tax rate.
- Limited partnerships allow each partner to restrict his or her personal liability to the amount of his or her business investment. Not every partner can benefit from this limitation; at least one partner must accept general partnership status.
The general partner has full personal liability for the business’s debts and obligations. The general partner retains full control of the business, while limited partners generally have little input into the management of the business. Both general and limited partners benefit from business profits.
- Limited liability partnerships are similar to limited partnerships, but give limited liability to every owner. An LLP protects each partner from debts against the partnership and they are not liable for the actions of other partners.
LLPs are a good choice for businesses with multiple owners and certain groups of professionals including attorneys, doctors, and accountants.
3. and 4. C & S Corporations
There are generally two types of corporations for small business owners to consider - S corporations and C corporations. Both are legal entities that are formalized with the filing of incorporation documents with the state.
The primary difference between the two types is in their tax structures:
- The C corporation is a tax entity in and of itself, so it files a tax return and is taxed based on the revenues of the business. The main reason to set up your small business as a C corporation is to be able to attract a bigger pool of investors and have more options for expanding your business. Double taxation could occur when the shareholders or owners file individual tax returns based on any income they receive in the form of dividends from the corporation.
- An S corporation is similar to a partnership and LLC in that it files an informational return. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.
In most other aspects, the two types of corporate structures are the same. In both cases, the business is controlled by a board of directors that is answerable to the shareholders.
A corporation is considered a separate legal entity with its own rights, liabilities, and obligations. As an owner, you have limited liability in a corporation, which means that your personal assets are protected.
5. Limited Liability Company (LLC)
An LLC is a separate legal entity from the business owner and acts as its own legal person. If you want to form an LLC, you’ll have to register it with the state.
The biggest benefit of LLCs is that your personal assets will have an extra layer of protection. If there’s a judgment against your business, it will be your business’s assets that will be liable, not your personal assets.
Factors to Consider When Selecting an Ownership Structure
When making a decision about what type of business structure to select, there are three major factors to consider.
When selecting an ownership structure, consider the nature of your business and the level of risk involved. Protecting your personal assets from potential losses associated with running your business is critical.
If your business lends itself to potential liability, and if you can’t personally afford the risk of that liability, a sole proprietorship or partnership may not be the best option. Protecting personal assets is why many business owners choose to incorporate.
Minimizing tax liability can make a big difference in profitability for small business owners. There are more tax options available to corporations than to sole proprietorships or partnerships. Double taxation, which is a common disadvantage associated with incorporation, can be avoided by choosing S corporation status.
Cost of Formation and Ongoing Administration
Some forms of ownership come with strict compliance requirements and meeting those can require significant time and money. Sometimes the high cost of recordkeeping and paperwork, as well as the costs associated with incorporation are among the reasons small business owners choose a sole proprietorship.
Determining the Right Structure for Your Small Business
As you develop your business plan, it’s a good idea to compare the types of business structures that are available before choosing one. The state your business is located in can have an impact on the business structures available to you. The kind of entity you form can have a significant impact on your professional and personal finances.
Selecting a business entity should be made in consultation with an experienced tax accountant or business attorney. These professionals will be able to explain the best options for your particular situation and help you make an informed decision.
Orcutt & Company is a full-service financial solutions provider. Our comprehensive service plans are designed with the small business owner in mind.
We can handle your bookkeeping, payroll, corporate and personal taxes in one office, with one point of contact. Our integrated approach is designed to ensure that we understand your personal goals and how they integrate with your business finances.
Consultation is fundamental to all our business services. Through our annual review with owners, we look at tax projection, the status of the business, and more.