When starting a small business, choosing the best legal structure is one of the most important decisions you can make. This decision will impact critical aspects of the business, including how much you are required to pay in taxes and the extent of your personal liability for financial debts and losses. However, determining which type of structure is best suited for the particular needs of your business is not always straight forward.
To maximize the opportunity for your business to become a success, take the time to understand the advantages and disadvantages of each type of business entity. This will allow you to consider how each structure may affect your small business.
It is important to choose your business entity carefully. While it is possible to convert to a different business structure in the future, changing business entities can be complicated. For example, it is not as easy to convert from a more complex structure to a simpler one. Furthermore, there may be restrictions based on where your business is located.
Legal Structure Options
Before registering your business with your state, you must elect a business structure. You have several options to choose from. The most common types of business structures include C corporations, limited liability companies (LLCs), partnerships, S corporations, and sole proprietorships.
Which structure is best for your business?
The Small Business Administration (https://www.sba.gov/ ) recommends selecting a business structure that provides the best balance of legal protections and benefits. With so many factors to consider, this decision may feel overwhelming. You can simplify the process by answering the following questions.
1. What is the most common structure used by a businesses?
The legal structure chosen by a business if often a function of how many employees are involved in the business. For example, a majority of non-employer businesses, or those with no paid employees, are structured as sole proprietorships. Keep in mind, however, that a business which has paid employees can also be structured as a sole proprietorship.
Most small employer businesses are structured as S corporations. The definition of small employer varies by industry, but these businesses typically have 500 employees or less. On the other hand, the SBA states that some companies which have as many as 1,500 employees can still be considered small.
Among large employer businesses, most are structured as corporations. According to the SBA size standards, classification as a large employer varies depending on the industry.
2. Are you starting your business with someone else?
The number of co-founders will also have an effect on the type of business structure that will be ideal for your business. If you are starting a business on your own, you can elect to be a sole proprietor, single-member LLC, corporation, or an S corporation. If you are starting a business with someone else, you can structure as a partnership, multi-member LLC, corporation, or as an S corporation.
3. How important is limited liability to you?
The legal entity you choose will influence whether you are personally liable for business debts. To prevent putting your personal assets at risk, you may want to consider choosing a business structure that offers limited liability. When a company has limited liability protection, a legal distinction is made between the owner and the business, which means that personal property and assets are not on the line if the business is sued or cannot pay its debts. Generally, the extent of your financial liability is the amount that you have invested in your business.
If you choose a business structure that does not offer limited liability, your personal assets are not protected. However, there are different types of insurance available that can help you manage the risk of running a business without limited liability protection.
The business structures that offer limited liability include LLCs, corporations, S corporations, and limited liability partnerships (LLPs). Sole proprietorships and general partnerships have no liability protection, and may put your assets at the greatest risk.
4. What kind of tax responsibilities do you want?
The type of business entity you form will have a large impact on how you are taxed and what tax returns you file. As a small business owner, it is your responsibility to pay taxes on business income, and choosing the best business structure can lead to huge savings at tax time.
If you structure your business as a sole proprietorship, partnership, LLC, or an S corporation, it will be classified as a pass-through business that does not pay taxes. This entity was designed to reduce the effects of double taxation, which means that you will only pay taxes on income on an individual level and not on a corporate level.
On the other hand, if you structure your business as a C corporation, you face the possibility of double taxation. This is because the C corporation is taxed as a separate entity that pays taxes at the corporate level. As an individual shareholder, you will also be taxed for any income you received in the form of a dividend.
5. How do you want to pay yourself?
Your personal income depends on the business structure you select. If your business is incorporated, you will receive a salary as a small business owner. If your business is not incorporated, you can draw an income from your business earnings and adjust your pay based on how well the business is doing. In this case, employee taxes are not automatically deducted and you are responsible for self-reporting any draws and paying taxes on them.
When you actively work as an employee of your incorporated business, you will receive a salary. If you are not actively working in your corporation, you will receive dividends. If you choose to structure your business as an S corporation, you can receive both a salary and regular distributions.
6. What kind of control do you want?
When deciding on a legal structure, you also have to consider the level of control you want to have over your business. If you are looking to have complete control of your business, a sole proprietorship or single-member LLC is the best option. In a partnership, the general partner may also have complete control.
When you are the co-founder of a business, control is shared with other partners, members, or shareholders according to the partnership agreement.
7. Do you have the time and money to handle a complex structure?
The easiest business structure to form is a sole proprietorship, which also has the least amount of government regulation. Partnerships are relatively easy to form as well, and can be started with as little effort as a handshake. However, a partnership agreement should be drafted to protect your interests as a co-founder.
To structure your business as an LLC, articles of organization must be filed with your state and fees are usually required. There are further requirements that must be met in certain states, such as publishing an announcement in a local newspaper.
The most time consuming business structure to develop is a corporation. For a C corporation, you must pay fees, appoint directors and officers, file articles of incorporation, and issue stock certificates.
To form an S corporation, there are additional steps that must be taken after incorporating your business. For example, you will need to file an S Corporation Tax Election (Form 2553), which instructs the IRS to tax your LLC as an S corporation. This can significantly lower the amount of your income that is taxable.
8. What does your business vision look like?
It is common for small business owners to have tunnel vision when they are first starting out. However, you must consider the future of your company when choosing a business entity. Otherwise, you may have to quickly convert to a new business structure, which can be a very complicated process.
For example, if you expect to expand your business in a major way, a corporation is your best option. You can still expand with other business structures, but corporations tend to be more attractive to investors.
You should also anticipate what you want to do with the business when you retire. You may plan on transferring the company to someone else, or have an exit strategy that involves closing down the business entirely.
Partnerships and sole proprietorships are usually dissolved once the owners leave. On the other hand, LLCs and corporations are considered separate legal entities, which means that the business continues even after you are no longer in the picture. If you wish for your partnership or sole proprietorship to continue after you leave, you should proactively explore your options for selling the business.
Which business structure should you choose?
When it comes to deciding which structure is best for your small business, there is no standard answer. Each company has its own unique set of circumstances, and requires different factors to be taken into consideration.
The following is a quick reference guide to the pros and cons of each business entity:
A sole proprietorship may be your best option if you are going into small business ownership by yourself and want a simple business structure. Your business will be classified as a pass-through entity, but it is important to keep in mind that this structure does not offer the protection of limited liability.
If you are starting a business with at least one other person, you may choose to structure your business as a partnership. Like sole proprietorships, partnerships are easy to form and qualify for pass-through taxation, yet do not offer limited liability.
If your goal is to obtain both limited liability protection and pass-through taxation, you may opt for an LLC or an S corporation. When you choose one of these business structures, it is important to note that they require more paperwork and startup fees compared to sole proprietorships or partnerships.
Large businesses are most often structured as C corporations. This type of business entity will provide you with limited liability protection and a business that continues after you leave. On the other hand, management and tax filing requirements will be more complicated if you choose to structure your business as a C corporation.