This post was originally published on May 18, 2016, and was updated on October 25, 2019.
With so many things to think about when starting a business, it can be tempting to go the path of least resistance, or what seems like the easiest option when choosing a business structure (aka business entity). For more than 23 million U.S. entrepreneurs, that’s setting up shop as a sole proprietor.
While going that route requires minimal paperwork and compliance formalities compared to other business entity types, it may or may not be the ideal choice.
So, what should you consider when deciding on a business structure for your startup or growing company?
In this post, I’ll share some basic information about several popular business entity types to give you an understanding of their potential advantages and disadvantages.
Realize that choosing a business entity type is one of the most impactful decisions you’ll make as an entrepreneur.
It will affect your legal liability as an owner, your tax obligations, your growth potential, and the degree of ongoing requirements you need to satisfy to operate your business — all good reasons to consult with a licensed attorney, accountant and tax advisor for guidance as you weigh the pros and cons.
Related: Legal issues for startups
The basics of business entity types
Let’s start with some fundamentals about different types of business structures.
Sole proprietorships and general partnerships
When a business is not formally registered with the state, it will be considered either a sole proprietorship (one owner or a married couple) or general partnership (multiple owners). The business is not its own separate legal and tax-paying entity; therefore, all assets and liabilities are tied to the business’s owners.
Advantages of running a business as a sole proprietorship or partnership
Attractive characteristics of operating as a sole proprietorship or partnership include:
Administrative simplicity – Aside from filing a DBA (fictitious name registration) if owners want to use a business name that doesn’t include their first and last names, there’s typically no legal formation paperwork required to operate either of these entity types.
Compliance filings and reports are minimal as well. Business profits and losses flow through to the business owners’ individual tax returns, keeping tax filing simple, too. All business income and expenses get reported on Schedule C of IRS Form 1040.
Related: What is DBA?
Inexpensive setup – Aside from the cost of filing a DBA and obtaining any necessary licenses and permits to operate legally, the administrative costs to start as a sole proprietorship or general partnership are minimal.
Disadvantages of running a business as a sole proprietorship or partnership
The ease of administration and low-cost setup may not be quite as appealing when considering the potential drawbacks, however.
Liability risks to owners – Sole proprietorship and partnership owners are considered to be the same legal and tax-paying entity as their business. That means if someone sues the business or the business can’t pay its financial debts, a court might rule that the owners’ homes, cars, retirement accounts, etc. be taken as restitution.
Significant self-employment tax burden – All of the income of a sole proprietorship or general partnership is subject to Social Security and Medicare taxes. That can add up over time.
Limited growth opportunity – These types of businesses cannot sell stock to fuel their growth, and outside investors typically favor funding businesses that are formally registered business entities (e.g., LLC, corporation). Therefore, it may be challenging to raise money to finance expansion or new initiatives.
Inability to sell the business – While sole proprietorships and partnerships may sell the assets belonging to the business, the entity itself cannot be sold. Also, if the business has outstanding debt, the owners will remain responsible (unless reaching an agreement with creditors) even if they are no longer actively operating the business.
LLC (limited liability company)
Business owners who want to keep setup and compliance uncomplicated while gaining some of the advantages of a corporation often gravitate toward the LLC business structure.
The IRS and most states view the LLC as a “disregarded entity” for tax purposes, meaning that an LLC’s profits and losses flow through to the owners’ personal tax returns. From a legal standpoint, however, an LLC is considered a separate entity from its owners (called “members”).
An LLC can be either a Single Member LLC or a Multi-Member LLC. States require filing Articles of Organization (or Certificate of Organization) to form an LLC. The cost to file varies by state.
It’s also beneficial, although not required by the state, to have an Operating Agreement, that describes the rights and responsibilities of LLC members and sets forth how the business should be run.
Advantages of the LLC business structure
Here’s a summary of the pros of operating as an LLC:
Ease of administration – Tax filing is about as simple as for sole proprietorships and partnerships. An LLC disregarded entity doesn’t have to file a corporate tax form. Also, LLCs have less ongoing compliance requirements than corporations.
Limited liability for owners – Because an LLC is its own legal entity, if someone sues the business or the company swims in financial debt, the members’ personal assets are protected. (However, note that any personal actions by members that endanger or cause harm may not be covered by the liability protection of the LLC.)
Ownership and profit distribution options – Few restrictions limit who can own an LLC. Many states allow individuals, groups, corporations and other LLCs to form an LLC.
An LLC’s owners may choose how the business will allocate the company’s profits and losses among its members. This potentially allows for owners who devote more time and effort into the business to be compensated based on more than their monetary investment. Unlike a sole proprietorship or general partnership, ownership interests in an LLC may be sold.
Choice of management structure – A multimember LLC can be operated as either a member-managed LLC or manager-managed LLC.
What’s the difference?
A member-managed LLC’s owners carry out strategic decision-making and day-to-day operational and administrative responsibilities. In a manager-managed LLC, members appoint a manager or managers to run the business operations while members primarily stick to making high-level decisions. Most states will consider an LLC to be member-managed unless its formation documents specify the manager-managed management structure.
Tax flexibility – An LLC may elect to be treated as an S Corporation for tax purposes. An S Corp is still considered a pass-through tax entity; however, only income paid to LLC members on the payroll are subject to self-employment taxes. Profits paid as distributions are not subject to Social Security and Medicare taxes, so an LLC’s members may find that the S Corp election will lower their personal tax burden.
More clout – With “LLC” behind a business name, a company might be perceived as more credible and capable than a sole proprietorship or general partnership. Logically, that really isn’t a proper way to gauge a business’s capabilities, but as the saying goes, sometimes “perception is everything.”
Potential customers, investors, and project partners might perceive your business as more legitimate if you have “LLC” behind the name.
Disadvantages of the LLC business structure
Possible downsides to operating as an LLC include:
Limited growth potential – As an LLC, you may not issue shares of stock. Also, although your business may be thought of as more legitimate than a sole proprietorship, some investors might be hesitant to offer you funding.
Self-employment tax (still an issue for a disregarded entity LLC) – Unless an LLC elects S Corporation tax treatment, all of its business earnings will be subject to self-employment taxes. The disregarded entity LLC has this potential disadvantage in common with sole proprietorships and general partnerships.
Often known as a “C Corporation,” this entity type is considered by the IRS and state governments as a separate taxpayer and legal entity. Its income and expenses are tied to the business, not its owners (shareholders). Ownership of a corporation is through the issuance of stock in the organization.
Forming a corporation requires filing Articles of Incorporation (called Certificate of Incorporation in some states) to register the business. Corporations must follow internal and external corporate rules (such as appointing a board of directors, drafting bylaws, holding shareholders meetings, filing annual reports, etc.) to operate legally. The registration and compliance requirements and costs vary by state.
Advantages of the corporation business structure
Perks of operating as a corporation include:
Highest degree of legal protection for owners – A corporation is a wholly separate entity, legally and financially, from its owners (aka shareholders). Shareholders, directors and employees have protection from creditors of the corporation and under most circumstances are not held responsible in lawsuits against the business.
Greater growth potential – C Corporations may have an unlimited number of shareholders and can issue multiple classes of stock. Also, lenders, angel investors and other financial institutions typically are more eager to provide funding to businesses organized as corporations than to companies set up as other business entity types.
Tax flexibility – Corporations may choose to be taxed as a C Corp or as an S Corporation. Taxation as a C Corp means that profit gets taxed at the federal corporate income tax rate. Any of the profits then paid as dividend income to shareholders are then taxed again on the shareholder’s individual tax returns.
Alternatively, corporations that choose S Corp election have all their profits flow through to shareholders’ personal tax returns, thus avoiding the “double taxation” experienced with the default corporate tax treatment. Under some circumstances, such as when the corporate tax rate is lower than the tax rate for individuals, the default corporate tax treatment may be more advantageous.
Also, corporations are often eligible for more tax deductions than LLCs, partnerships and sole proprietorships. You can learn more about the differences between C Corps and S Corps, or ask your attorney or accountant for advice.
More credibility – By incorporating and having “Inc.” at the end of the business name, a company may find it’s easier to gain the respect and interest of investors, customers and project partners.
Perpetual life – Ownership interests in a corporation may be transferred via selling, gifting or bequeathing shares of company stock to others. A corporation continues to exist until it is formally dissolved.
Disadvantages of the corporation business structure
Several negative aspects of operating as a corporation include:
Higher costs and formalities to get started – In most states, incorporating a business as a C Corp costs more than forming an LLC. Also, there is more work involved, such as appointing a board of directors, preparing bylaws, filing an initial report and other state requirements.
Sting of double taxation – Often, small businesses opt not to incorporate because of the double taxation tax treatment. As I mentioned earlier, a C Corp pays taxes on its profits at the corporate tax rate. Then, if the company distributes profits to its shareholders as dividends, that income is taxed again at the individual income tax rate.
More ongoing compliance requirements – Tax rules and compliance requirements are more complicated for corporations than other entities. Also, “big brother” may watch corporations more closely for compliance adherence to ensure they’re following all the rules.
Less growth potential for S Corps vs. C Corps – S Corporations may only have up to 100 shareholders, whereas C Corps can have an unlimited number. This may be a disadvantage for corporations that want the S Corp pass-through tax treatment, but that also want to expand.
Questions to help you sort it out
Getting trusted legal and accounting guidance will help you figure out the best entity type for your situation. In the meantime, here are some questions to consider as you prepare to understand which business structures may be worth exploring further:
- Are you worried that your business activities might put you at risk of losing your personal assets? If so, you may find yourself losing sleep at night when operating as a sole proprietorship or general partnership.
- Do you want flexibility in how your income taxes can be handled? Sometimes corporate income tax rates are more favorable than a business owner’s individual tax rates and vice versa. The LLC and corporation structures allow business owners to choose tax treatment that will most benefit them.
- Will you need funds beyond your own to start and grow your business? Corporations may sell stock to finance their operation. Also, investors often show more willingness to consider funding a company set up as a corporation rather than other entities.
- Does your personal privacy matter? With an LLC or corporation, the company’s registered agent (an authorized party designated to receive service of process, such as legal and government notifications) goes on public record rather than the owner’s home address.
Of course, this is just a sampling of the many questions you’ll want to think about as you consult your attorney and tax professional when choosing a business entity type.
Also, realize that the business structure that’s ideal for your company in its early years may not remain the perfect entity type for the long term. It’s wise to re-evaluate your business structure each year to ensure it’s still the one that’s most favorable for your current situation.
The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
The post Sole proprietorship? LLC? S-Corp? Know your business entity options appeared first on GoDaddy Blog.
Source: Go Daddy Garage
Republished by Blog Post Promoter