Whether you’re considering starting a business, or have been in business for many years, the right business structure can mean the difference between success and failure. The term “business structure” refers to the way a business is organized: who owns the company, how profits are distributed, and who performs what jobs. In addition, different business structures have their own tax and liability issues.
Types of Business Structures
In the United States, the three business structures recognized by the IRS are sole proprietor, partnership, and corporation. Other structures that are legally important are Limited Liability Company (LLC), S-Corporation and C-Corporation.
Before you can decide how you want to structure your business, you’ll need to know what your options are. Here’s a brief rundown on the most common ways to organize a business:
A sole proprietorship, or one-person business, is a common business structure for new businesses. You become a sole proprietor just by going into business for yourself. There is no paperwork or registration involved, though you can get a DBA (“doing business as”) license or registration at your local county office. In legal terms, a sole proprietorship is where the business and the owner are one and the same. For tax purposes, the owner of the business reports business income and losses on his or her personal tax return and is personally liable for any business-related obligations, such as debts or court judgments.
Similar to a sole proprietorship, a partnership is a business owned by two or more people. The partnership operates as soon as you start a business with another person, and requires no paperwork. For tax purposes, the partnership’s owners pay taxes on their share of the business income on their personal tax returns and they are each personally liable for the entire amount of any business liabilities. The only exception to the two-person rule is if two spouses go into business together. For all intents and purposes, a spousal business is still seen as a sole proprietorship in the eyes of the law.
C-Corporations and LLCs
While forming and running a corporation or LLC is more complicated and expensive than a sole proprietorship or partnership, it can be well worth the trouble for many businesses. An LLC or a corporation structure limits the owners’ personal liability for business debts and court judgments against the business.
Unlike other types of businesses, a corporation is an independent legal and tax entity, separate from the people who own, control, and run it. The corporation pays taxes on corporate profits, not the owners. Owners only pay personal income tax on money they receive from the corporation, such as salaries and bonuses.
Similar to corporations, LLCs, as their name implies, provide limited personal liability for business debts and judgments. Unlike corporations, LLCs operate more like partnerships for tax purposes. The owners of an LLC pay taxes on their part of the business income on their personal tax returns.
Businesses interested in forming a corporation can choose to become S Corporations, or S Corps. Before a business receives the S Corp designation from the IRS it must first become a corporation. Once a business receives the designation, the S Corp is considered separate from its owner, which limits the owner’s financial liability. It doesn’t protect an owner from all legal judgments, such as workplace or employee issues.
The other benefit of an S Corp is that profits and losses pass through to the owner’s personal tax return, and the C-corporation problem of being double taxed (once as a corporation and again as a shareholder) is avoided.
What’s the Right Choice for Your Business?
There are pros and cons to each type of business structure. Here are the main factors to consider:
- Liability and Asset Protection: If you’re concerned about liability, or have personal assets you want to protect, you might consider a corporation or LLC. Otherwise, a sole proprietorship or partnership might work just fine for you.
- Taxes and Fees: Double taxation is a hard pill to swallow, which is why only large businesses choose to be C-corporations. The fees for C- and S-Corps, and LLC, are also higher, so this should be weighed against the need for liability and asset protection.
- Investors: Only corporations allow you to offer stocks. If you are considering adding investors, you should consider this option.
- Ownership: Corporations and LLCs allow you to transfer ownership. This would be an important consideration if you want to sell your company at some point, or if you otherwise can no longer run the company.
Choosing or changing your business structure is something not to be taken lightly. Potential issues include liability, taxes, investors, and ownership. Your accountant and attorney are critical resources in helping you make this important decision.
Onwards and Upwards.