One of the first difficult decisions you must make when starting a business is choosing your business entity type. It can get confusing to research what the differences are and what each entity means. I will be breaking down each one below so that you’ll have a better understanding of just what you can set up.
What is a Business Structure?
A business structure is a legal/government classification which determines several factors in your business. Your type of entity determines the type of taxation used for your business, the personal liability attached to it, and lastly how much and what type of paper work you must file. These factors can become obstacles if you choose the wrong entity which is why it is important to research before your form one. Of course, you can always change your entity in the future, but it usually involves a lot of confusion between your business and IRS!
Sole Proprietorship
A sole proprietorship is the most common entity used by small businesses because it can often be the simplest. It’s formed with minimal paperwork in some states and absolutely none in others. Due to there only being a single owner, this person has complete control of the company. This is usually the easiest entity to start but can also be one of the most risky.
One of the biggest obstacles for sole proprietorship is the lack of boundaries for liability. There is absolutely nothing separating personal assets and liabilities to the business. This entity works as one with the person and company which means if one gets sued, the other one typically does as well. It also means that there is no separation between the entity and person when it comes to income taxes. This is because the tax liability for the business profit must be reported on the owners personal tax return.
Partnership
A partnership is formed by two or more people. It can be done formally with an operating agreement or with something as simple as a handshake. But unlike the sole proprietorship, there needs to be clear guidelines for who is liable for how much and who has the main control. The reason for this is there must be one general partner who has unlimited liability attached to personal assets. The other partners typically will only have liability up to and including the money or property they contributed to the partnership. Similar to a sole proprietorship, the individual partners wind up being the ones responsible for the tax liability associated with the business and report it on their personal returns.
Limited Liability Company (LLC)
The LLC allows you to take advantage of corporate benefits, but with some flexible elements of both the sole proprietorship and partnership. The biggest eye-catcher for LLC is the protection to personal assets. Unlike the two previous entities, LLC separates business liability from personal liability. This might be an important factor for many business owners, considering no one wants to be paying a business debt with their personal assets.
The LLC allows profits to get passed to personal income without the “company” paying the taxes. This also means that LLC members will not only pay income taxes but also self-employment tax towards Social Security and Medicare. One of the downsides of the LLC is the limited lifetime it could have in many states. If there are multiple members and one joins or leaves you may have to dissolve and reconstruct your LLC with the new changes.
Corporation
C-Corp: The C-corporation is the entity which is separate from its owners. This allows the most protection from personal assets. Due to the legal nature of the C-Corp offers, there is higher cost to set it up. Additionally, creating a C-Corp also requires more extensive record-keeping, operational processes, and reporting. Unlike a LLC, the shareholders in the corporation can sell or trade their stock and the corporation can keep functioning as is. Another advantage of having stock is the ability to raise funds through the sale of it.
Now, unlike the other other entities previously discussed, the C-Corp is ultimately responsible for it’s tax liability. This means that it doesn’t transfer over to the owners/shareholders. The only tax they will pay is on any wages they were paid and reported on a Form W2 or dividends are paid to them and reported on Form 1099-DIV. This is why some will say that C-Corps are subject to double taxation, once when they pay taxes on profits and secondly when shareholders have to pay taxes on their dividends.
S-Corp: S-Corps are very similar to the C-Corp expect it offers some benefits when it comes to taxation. This entity is designed to avoid double taxation for corporations therefore, the S-Corp allows profits to pass directly to shareholders’ income without being taxes at corporate tax rates. Additionally, S-Corps do not subject their owners to Self-Employment taxes on their personal tax returns unlike sole proprietorships, single member LLCs and partnerships.
Now it’s important to note that a S-Corp is not created at the state level; it’s a designation with the Internal Revenue Service (IRS). There are a couple of requirements that the corporation must meet before becoming S-Crop. Some of these requirements include but are not limited to; must have just one class of stock, no more than 100 shareholders, be a domestic corporation, and have only allowable shareholders. To learn more about S-Corps from the IRS, check out this page on their website.
Non-Profit Entity
A non-profit organization is self-explanatory; the purpose of the corporation is to contribute good to the community rather than generate profits. This entity gets an exemption from taxation once it receives approval from the IRS. In order to qualify for this, there is a list of special requirements that must be followed regularly to be considered a non-profit corporation. To learn more about the tax information for charitable, religious, scientific, literary, and other organizations exempt under Internal Revenue Code (“IRC”) section 501(c)(3) check out this page from the IRS’ website.
If you would like to learn more about the different types of business structures, we recommend looking at the Choose A Business Structure page over at the SBA’s website.