How To Choose The Best Legal Structure For Your Business
Choosing the right legal structure is a necessary part of running a business. Whether you’re just starting out, or your existing business is growing, it’s important to understand all options.
Your business structure will affect how customers, partners, and creditors view your company as well as how it will be taxed, what type of liabilities it will incur, and what types of state and federal laws will govern it.
Chances are, you’ve heard terms like corporation and partnership numerous times, but you may not be sure of their exact legal definitions let alone the advantages and disadvantages they carry with them. As a result, you want to consult with your business tax advisor or CPA for the best answers and options that fit your unique situation. Let’s dive into six of the most common business structures.
→ Sole Proprietor
→ Limited Liability LLC
→ C Corporation
→ S Corporation
→ Nonprofit Corporation
A proprietorship is perhaps the simplest form of entity, but in many cases it is also the riskiest. It’s nothing more than you, individually, doing business under either your own name or a trade name. Its simplicity provides little paperwork or legal planning. Taxes are reported on your personal return. Profits and losses come out of your own pocket. You alone make all of the decisions.
Some of the biggest drawbacks however are, as the owner, you are fully liable. If business debts become overwhelming, the individual owner’s finances will be impacted. Self-employment taxes apply to sole proprietorships and raisingcapital is difficult.
This entity is owned by two or more individuals. There are two types: a general partnership, where all is shared equally; and a limited partnership, where only one partner has control of its operation while the other person(s) contributes to and receives part of the profits. Partnerships carry a dual status as a sole proprietorship or limited liability partnership (LLP), depending on the entity’s funding and liability structure.
With a partnership, there is little paperwork and you’re more likely to obtain a business loan as lenders can consider two credit lines rather than one. Taxation requires you to fill out federal tax Form 1065 and state returns. Both partners report their shared income or loss on their individual income tax returns. Profits and losses may be passed through to the owners’ personal income for tax purposes. Debts and liabilities pass through as well. (1)
Limited Liability Company
An LLC, by definition, is a partnership in the eyes of the IRS. It pays no tax itself, instead it’s profits are taxed only once in the member’s personal returns and it shields member’s personal assets from business creditors. The LLC’s combination of tax simplicity and liability protection have made it the entity of choice for new small business.
With an LLC, you can always elect to be taxed as an S-Corp down the road, or, once your business really takes off, you can change into a new structure. Some drawbacks are the ongoing filings and fees to stay in compliance as well as LLCs can’t go public. (2)
The C corporation structure is more complex than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires complying with more regulations and tax requirements. A corporation’s debt is not considered that of its owners, so if you organize your business as a corporation, you are not putting your personal assets at risk. (3) A corporation also can retain some of its profits without the owner paying tax on them. A corporation can sell stock to raise funds.
One of the drawbacks is a corporation must follow more complex rules and regulations than other entities. Owners of the corporation pay a double tax on the business’s earnings. They are subject to corporate income tax at both the federal and state levels. Any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns. A business tax advisor and CPA can help you strategize how to ease the pain of double taxation as well as help with complying with the complex requirements.
The S corporation is more attractive to small business owners than a regular (C) corporation. That’s because an S corporation has some appealing tax benefits. Essentially, an S corp is any business that chooses to pass corporate income, losses, deductions, and credit through shareholders for federal tax purposes, with the benefit of limited liability and relief from double taxation. Your family members can be considered a shareholder.
S corps must file with the IRS to get S corp status. There are special limits on S corps, such as no more than 100 shareholders, and all shareholders must be U.S. citizens.
Nonprofit corporations are organized to do charity, education, religious, literary, or scientific work. Since their work benefits the public, nonprofits can receive tax-exempt status, meaning they don’t pay state or federal taxes or income taxes on any profits it makes. Nonprofits must file with the IRS to get tax exemption, a different process from registering with their state. (4)
Nonprofit corporations need to follow special rules about what they do with any profits they earn. Nonprofits are often called 501(c)(3) corporations — a reference to the section of the IRS code that is most commonly used to grant tax-exempt status.
Where do you stand?
Are you starting your business with someone else? What kind of tax responsibilities do you want? How do you want to pay yourself? Do you have the time or expertise to understand complex structures and their tax consequences?
Choosing the right business structure can be tricky. Jeanine Hemingway CPA can walk you through the pros and cons of each and advise on the tax implications each carries. Contact us today at (512) 291-9955