Choosing the Right Business Structure¹
A business’s structure can affect everything from the way it is managed to the liability exposure its owners face. By choosing the right structure, you’ll get your business off to a good start and minimize problems down the road.
Small businesses have several options. You can create a business entity such as a corporation or LLC by filing organizational documents with your state. Or you can decide not to create a formal business entity and your business will automatically be a sole proprietorship if it has one owner and a general partnership if it has more than one owner.
Types of Business Structures
Sole proprietorships are the simplest business structure. The business and its owner are really one in the same. The owner reports all business income and expenses on his or her personal income tax return. The owner is also personally responsible for all business debts.
General partnerships have a lot in common with sole proprietorships: partners report business income and loss on their personal tax returns, and the partners are liable for any business debts. In addition, general partners may be held liable for one another’s negligence or for the negligence of an employee. Each partner is also personally responsible for the entire amount of the business’s debts.
Limited partnerships have one or more general partners who are personally liable for business obligations. They also have limited partners who act as investors and are not involved in managing the company. For these limited partners, liability is limited to the amount they have invested in the business.
Corporations offer personal liability protection to their owners, who are called “shareholders.” Because a corporation is a separate business entity, its shareholders are not ordinarily liable for business debts and obligations. Their risk is limited to the amount of money they have invested in the company. This liability protection is a major reason for forming a corporation.
Corporations have an established management structure consisting of officers who run the day-to-day business and directors who oversee the company’s overall plans and direction.
“S corporations” and “C corporations” aren’t types of business entities. The “S” and “C” refer to a corporation’s tax status with the Internal Revenue Service. By default, all new corporations are considered C corporations. A C corporation pays corporate income tax on its profits. Its shareholders then pay personal income tax on any distributions they receive.
To avoid this double taxation on distributions, some corporations file a form with the IRS electing to be taxed as S corporations. An S corporation doesn’t pay corporate income tax. Its profits and losses pass through to the shareholders’ personal tax returns, and each shareholder pays personal income tax on his or her share.
A business must meet certain qualifications to be an S corporation, including having 100 or fewer shareholders, having no corporate or foreign shareholders, and having only one class of stock.
Limited liability companies, or “LLCs” offer the same liability protection as corporations, but with greater tax and management flexibility. LLCs tend to have fewer administrative and recordkeeping requirements than corporations.
While corporations have a rigid management structure, LLCs can be managed by their owners, or “members,” or they can be managed by a group of people who serve as managers. LLCs have the flexibility to divide profits in any way they choose, whereas corporations must distribute profits according to the number of shares each shareholder owns.
LLCs also offer tax flexibility. The IRS does not have a separate tax classification for LLCs, so LLCs are taxed as if they had a different business structure. By default, all LLCs are taxed as “disregarded entities,” which means that a single-member LLC is taxed like a sole proprietorship and a multi-member LLC is taxed like a partnership.
An LLC can also elect to be taxed as a C-corporation by filing a form with the IRS. An LLC that meets the requirements for S-corporation taxation can file an additional form and elect to be taxed as an S corporation.
How to Decide
When choosing a business structure, it’s wise to get advice from a business lawyer. A tax accountant experienced with small businesses can also offer valuable guidance on the tax aspects of your choice. Here are some common reasons that a small business owner might choose one type of entity over another.
- A freelancer or independent contractor who has no employees or subcontractors and faces minimal liability exposure may choose to remain a sole proprietor because it is the simplest business structure and there are no costs to form or maintain a sole proprietorship.
- A business that wants to avoid corporate income tax and have profits and losses flow directly to the owners’ personal tax returns can form an LLC or a corporation that elects S-corporation taxation. If a business is not eligible to be an S-corporation, the only way to obtain both liability protection and pass through taxation is to form an LLC.
- Many small business owners form LLCs because of their flexibility and personal liability protection.
- A business that wants to attract venture capital or anticipates going public should be a corporation.
- A corporation is often the best structure for a business that wants to use shares in the company to compensate people who worked for the business during its startup phase.
- Although C corporations often pay more in taxes than S corporations or LLCs, this may not be true if the corporation keeps most of its profits in the business instead of distributing them to shareholders. A business that is saving money for a future expansion may benefit from being taxed as a C corporation.
Forming a Business
To form a corporation, LLC or other type of business entity, you must file organizational documents with the state agency responsible for business filings. The secretary of state serves this function in most states.
These organizational documents consist of a relatively simple form that can be found on the business agency website. The website also has information about filling out and submitting the form, choosing a name for the business, and selecting a registered agent to receive service of lawsuits and other documents on the business’s behalf. There is a fee for filing organizational documents, but the exact amount varies from state to state.
New LLCs also need an operating agreement, and corporations must have bylaws. These documents describe how the business will be managed, the rights of its owners, and the procedure for admitting new owners or dealing with departing ones. In the case of LLCs, the operating agreement can also specify how profits and losses will be apportioned among the members. Bylaws and operating agreements aren’t filed with the state, but they provide important guidance as a business grows and changes.
Once paperwork is filed with the state, your business will receive a certificate. Most businesses must then obtain a federal employer identification number from the IRS website. Your business may also need to register with state and local taxing authorities and obtain licenses and permits.