The best business structure for you will depend on many factors, including how you plan to take and maximize deductions, what type of businesses you work with, and if you intend to grow your business in the future.
Review the advantages and disadvantages of each structure to choose the best option for your small business.
Deciding how to structure your business is an important consideration, one that can carry tax and compliance implications.
- What is a legal business structure?
A business structure is the legal structure of an organization that is recognized in a given jurisdiction for a business category. The type of legal structure you choose determines the extent to which you can participate in certain activities such as raising capital and the amount of taxes you pay. The structure also influences the day-to-day operations of your business. It defines who owns the company, how profits are distributed, and who is responsible for performing which tasks. The structure also determines how the business will be taxed and the responsibilities of managers and owners in the event of a lawsuit.
The following four structures are discussed with the following assumptions:
- Your business has one owner with no additional shareholders;
- You do not require investors;
- You wish to keep business administration to a minimum;
- You do not have the need for a Board of Directors; and
- You wish to minimize legal and tax exposure.
- Four Types of Business Structures for Small Business
The first step is to understand the distinct types of legal entities. The most common types are sole proprietorships, limited liability companies (LLCs), and corporations.
The next step is to understand the factors that you should consider when choosing a legal entity for your startup. These include:
The type of business you are starting: Different businesses have different legal requirements. For example, businesses that require a lot of capital may be best suited as a corporation.
Your personal circumstances: Your personal circumstances, such as your financial situation and your liability risk, should be taken into account when choosing a legal entity.
The jurisdiction in which you are starting your business: The laws of different jurisdictions can have a significant impact on the choice of legal entity. For example, some jurisdictions may not allow sole proprietorships or may have special requirements for corporations.
After you have considered these factors, you should consult with a lawyer or accountant to help you choose the right legal entity for your startup.
Each of the four business structures below has advantages and disadvantages and has tax implications that need to be considered. As you read the options, consider your future plans for your business, how flexible you need to be, and the responsibilities you are willing to undertake.
- Sole Proprietor
A sole proprietorship is the simplest type of business entity. It is owned by one person and is not legally distinct from the owner. This means that the owner is personally liable for all debts and obligations of the business.
Many independents begin their journey as sole proprietors. For tax purposes, you operate under your personal Social Security number, but you can apply for a Taxpayer Identification Number (TIN) for your business by filing a form IRS SS-4 asking for an Employer Identification Number (EIN) as your TIN instead of using your personal Social Security number.
The business is run under your legal name. If you want to give the business an alternate name, you will register a Doing Business As (DBA) to state the name you intend to give your business. This process lets your state or local government know the name you are operating your business under. Specific DBA registration rules vary from state to state. You may also apply for a Federally registered business trademark or trade name.
Sole Proprietor Advantages:
- Sole Proprietors file on a Schedule C (quarterly) but are taxed the same on their personal and business income.
- Filing only one form each year means less paperwork and hassle.
- Provides flexibility for those still fully employed and freelancing only part-time.
Sole Proprietor Disadvantages:
- Does not offer corporate protection of your personal assets. This means there is no legal difference between you and your business assets. If you are sued or go bankrupt, your personal assets are attached to your business and will be available to debtors.
- Limited Liability Company (LLC)
An LLC is a business entity that combines the features of a corporation and a partnership. LLCs are owned by one or more members, who are not personally liable for the debts and obligations of the business. An LLC is a business entity that combines the features of a corporation and a partnership. LLCs are owned by one or more members, who are not personally liable for the debts and obligations of the business.
Originally designed to protect owners of a business from certain business-related liabilities, the LLC structure has since become popular for independents due to its simplicity, yet strong legal protections of a corporation shielding your personal assets. Think of it as the next step above a sole proprietorship.
- Simple and inexpensive to set up; requires less paperwork than C and S Corporations.
- For the purposes of taxes (unless a special election is made), a single-owner LLC is not considered a distinct, separate entity, but does offer some protection legally from things like non-guaranteed debts and court judgments.
- Seen as a “first structure” that independents seek to have some measure of legal protection.
- If you take some actions, including but not limited to actions like personally guaranteeing a debt, becoming a personal part to a contract, or if you co-mingle your personal funds and activities with your LLC business activities, you can be exposed to “piercing the corporate veil,” and be held personally liable for the LLC’s obligations.
- You still have an obligation to operate your business as a separate entity to ensure you retain the value of the limited liability of the LLC.
- Earnings from LLCs are typically subject to self-employment taxes. While you won’t incur corporate taxes as you do with other structures, you’ll account for any profits of the LLC on your personal tax returns. Some states may also charge extra “franchise tax” on LLCs.
- Subchapter S Corporation or S Corp
A corporation is a business entity that is owned by shareholders. The shareholders are not personally liable for the debts and obligations of the business.
Also referred to as an S-Corp, this is a business structure that has received the Subchapter S designation from the IRS. According to the IRS, S-Corps are considered by law to be a unique entity, separate and apart from those who own it. With this structure, subject to similar exceptions as described above for LLCs, you have the limited legal liability (separation of personal assets from your business) of a separate legal corporate entity as well as the separate tax entity.
Provided the owners are eligible to make and make a timely election with the IRS, the profit from your business is reported under a separate tax return filing form IRS 1120S, but the taxable profit passes through to your personal tax return on form 1120 K-1. Thus, there is just a single level of tax.
S Corp Advantages:
- Profits and losses pass through to the shareholder’s personal tax return (whether or not actually distributed). This means that the business is not taxed itself; only the shareholders. However, there is an important caveat: any shareholder who works for the company must pay him or herself “reasonable compensation.” Shareholders must be paid a fair market value, or the IRS may reclassify any additional corporate earnings as wages, and the S-Corp will need to pay employment tax—both the employer’s share of Social Security and Medicare taxes on all wages. Any leftover profit or loss is then passed through to the owner’s tax return via 1120 K-1 and is not subject to self-employment tax.
S Corp Disadvantages:
- The IRS is very tuned in to S-Corp owners who pay themselves a low wage to avoid self-employment tax.
- There is an audit risk for these personal services corporations and back taxes, interest, and penalties can be costly.
- C Corporation or C Corp
An attractive option for the savvy independent professional, C-Corps make owners shareholders. A C-Corp has the same status that Fortune 500 businesses hold—they are corporate entities separate from their owners. In the case of an individually owned C-Corp, you are not just the owner of your company, but the majority shareholder.
Because the corporation is a separate legal entity, it is an individual taxpayer in the eyes of the IRS. While this structure is one of the most complex business arrangements available, it is also the most sophisticated, making it an attractive option for independents.
C Corp Advantages:
- C-Corps are viewed as individual taxpayers by the IRS.
- Provide limited liability, separating your personal and professional assets if your company is ever sued (subject to exceptions, including those listed above).
- Fringe benefit deductions are available, including Health Reimbursement Arrangements (HRAs).
- Minimal taxes, as C-Corps pay FICA (Social Security and Medicare) taxes only on received wages.
C Corp Disadvantages:
- With separate entity status, C-Corps can be subject to double taxation (i.e., at both the corporate and at the shareholder level) from the IRS for profits and distributed as dividends. Double taxation can also occur when the business is sold.
- Owners of a C Corporation are not eligible for some deductions available to sole proprietors, or LLC or S Corporation owners in certain situations.
- Liability of an Entity
When choosing a legal entity for your startup, its important to consider the liability of the entity. The entity's liability will protect your personal assets from being used to pay off debts or judgments against the startup. There are several different types of legal entities, each with its own advantages and disadvantages.
Sole Proprietorship: The sole proprietor is personally liable for all debts and obligations of the business. This means that the sole proprietor’s personal assets, such as their home or car, can be used to pay off debts of the business.
Corporation: The owners of a corporation are not personally liable for the debts and obligations of the business. This means that their personal assets, such as their home or car, cannot be used to pay off debts of the business.
Limited Liability Company: The owners of an LLC are not personally liable for the debts and obligations of the business. This means that their personal assets, such as their home or car, cannot be used to pay off debts of the business.
- Taxation of an Entity
The taxation of a business entity depends on its legal structure. There are four common business structures in the United States: sole proprietorship, LLC, corporation, and S-corporation. Each has its own tax implications.
The owner of a sole proprietorship reports all business income on their personal tax return. This includes any income from the sale of goods or services, as well as any investment income. The owner of a sole proprietorship is also responsible for paying all business expenses.
LLCs elect whether they wish to have the income taxed as a partnership (where the LLC’s income and expenses are passed through to the members to declare on their personal income tax return) or as a corporation (where the income is double taxed).
Corporations file their own tax return and pay corporate income tax on their profits. Shareholders of a corporation report any dividends they receive from the corporation on their personal tax return.
S-corporations file their own tax return but their shareholders report the corporation's income or loss on their personal tax return. S-corporations are not subject to corporate income tax but they are subject to other taxes, such as payroll taxes.
- Social Media and E-Commerce Transactions
When it comes to choosing the right legal entity for your startup, there are a number of factors to consider. One of the most important factors is the type of business you will be conducting. If you will be selling goods or services online, then you need to take into account the laws governing e-commerce and social media transactions.
There are a few different types of legal entities that can be used for online businesses, including sole proprietorships, limited liability companies (LLCs), and corporations. Each type has its own advantages and disadvantages, as discussed above, so it's important to choose the one that best suits your needs.
Sole proprietorships are the simplest and most common type of business entity. They are easy to set up and require very little paperwork. The biggest downside of a sole proprietorship is that you, the owner, are personally liable for all debts and liabilities of the business. This means that if your business is sued or incurs debt, your personal assets could be at risk.
LLCs are a popular choice for online businesses because they offer limited liability protection. This means that the owners of an LLC are not personally liable for the debts and liabilities of the business. LLCs are also relatively easy to set up and maintain. The biggest downside of an LLC is that they can be more expensive to set up and operate than sole proprietorships or corporations.
Corporations are the most complex type of business entity. They offer their owners limited liability protection, but they also have a number of other advantages, including the ability to raise capital by selling stock. The biggest downside of a corporation is that they are subject to double taxation, meaning that the corporation itself and the shareholders who own it must both pay taxes on their profits.
When choosing the right legal entity for your online business, it's important to consider the laws governing e-commerce and social media transactions. You should also consider the advantages and disadvantages of each type of entity before making a decision.
- Closing and Aftermath
After you've decided on the legal entity for your startup, it's time to take care of some final steps. This includes:
- Filing the appropriate paperwork with the state or country where you're incorporating;
- Paying any filing fees;
- Obtaining any licenses or permits required for your business; and
- Opening a bank account in the name of your business.
Once you've taken care of these final steps, you're ready to officially launch your startup!
Now that you know the ins and outs of choosing the right legal entity for your startup, you can make an informed decision about what's best for your business. Just remember to keep in mind the factors we discussed, such as the type of business you're running, your goals for the future, and the amount of liability you're willing to take on. With this information in hand, you'll be well on your way to setting up your business for success.