Starting a business is exciting, you’re filled with optimism and ready to take on a new challenge. However, the excitement comes with mundane tasks. You could have to open new bank accounts, update tax filing information, and more. But first, you need to choose a business structure. Your business structure can impact everything from compensation to taxes, so choose wisely. This guide will tell you how to make an informed decision on your entity structure.
Business Structure Basics: What is an Entity?
A business should alwasy operate separately from your personal finances. The separation makes accounting easier and potentially limits your liability. Businesses should have their own bank accounts, credits cards, and tax-id to separate the business from your personal finances.
Common Entity Structures for Small Businesses
Small businesses have lots of business structure choices, including sole proprietorships, partnerships, LLCs, s-corporations, and c-corporations. Each business structure has benefits and drawbacks worth considering prior to starting your business. Sole proprietorships are the easiest to set up, but provide little to no liability protection. Corporations require considerably more work up front, but allow flexibility for tax planning. Below is a list of items to consider when selecting a business structure.
Ownership
The number of owners will restrict some of your options when it comes to entity structure. For example, sole proprietorships can only have one owner, and s-corporations can’t have more than 100 shareholders.
Tax planning
You should consider how your business structure will affect your tax strategy before you make a choice.
Liability risk
A proper entity structure can protect your personal assets in the event of a lawsuit against the business and visa verse.
Ease of Administration
Regulators typically require additional tax filing steps for business entites. Additionally, you might have to hire yourself as an employee and pay payroll taxes if you form a corporation.
Who Can Claim the Home Office Deduction?
Corporations have another notable drawback. Neither S or C-corporations can claim the home office deduction. However, sole proprietors, partners, and LLCs can claim the deduction. Take this into account when considering a potential business structure.
Sole Proprietorship
A sole proprietorship is a simple business entity tied directly to an individual business owner. The owner reports any income from the business on IRS Schedule C and submits it with their individual tax return. Sole proprietorships don’t require a “doing business as”(DBA) registration unless you’re using an alias or brand name. Sole proprietors can use their social security number to represent their business, but they can also request an IRS EIN if they desire.
The biggest benefit of a sole proprietorship is its simplicity. For example, they don’t have to file a separate tax return for the business. Instead, proprietors report their income and expenses on Schedule C of their personal tax returns. As a result, you will face minimal startup costs. However you can still obtain an employer identification number, which is recommended. Additionally, you can take advantage of the home office discount.
Unfortunately, the simplicity comes with some notable drawbacks. A lawsuit against your sole-proprietor business could threaten your personal assets. Also, you won’t have access to nearly as many tax-advantaged retirement options. Furthermore, sole proprietorships can’t exceed a single owner, although married-filing-jointly taxpayers can share ownership.
Despite the drawbacks, this business structure fits many small businesses. Simple businesses with few liability risks may find this is the best option for their circumstances. Many businesses begin life as a sole proprietorship, but you can always upgrade to a more suitable structure in the future if needed.
Partnership
A partnership shares many benefits with a sole proprietorship, but its notable distinction is its ability to include multiple owners.
Partnerships typically begin with a partnership agreement between two or more persons. General partnerships don’t usually require state filings, but the owners will need to file separate partnership tax returns. Partners share responsibility for the business, and they can pull money out of the business without significant red tape.
Unfortunately, partnerships provide almost no liability protection. A lawsuit could put all the owners on the hook for any resultant liabilities. Furthermore, partners must agree on any business decisions, which can often lead to internal disputes.
Many professional businesses organize themselves as partnerships because their professional liability is not limited by any business structure. Partnerships can also work especially well for joint ventures between businesses. Also, many family-owned businesses choose a partnership business structure because their interests are largely aligned.
Limited Liability Partnership (LLP)
Limited liability partnerships operate like partnerships, but they provide liability protection for each partner. The limited partnership shields each partner from liabilities exceeding their stake in the business. Companies organized this way must include “Limited Liability Partnership” or “LLP” in their business name to ensure full disclosure.
LLPs have flexible payment structures like a partnership. They also protect the partners from personal liability in the event of a lawsuit against the company.
However, LLPs must file a business tax return every year, and they don’t shield partners from personal liability due to negligence or professional misconduct. Most states require LLPs to register with its regulators and pay annual fees in addition to taxes.
In most states, LLPs must limit their membership to professional corporations formed by accountants, lawyers, or other professionals. As a result, most companies can’t choose this structure.
Limited Liability Company (LLC)
As the name implies, a limited liability company limits the liability of each of the owners to their share of the company’s assets. As long as the separation between the business and owner, a lawsuit against the business cannot go after the owner’s personal assets.
The company has the option of being taxed as a partnership or a corporation. To elect to be taxed as a corporation, the company must file an election with the IRS. Each member’s liability is limited to their share of the company’s assets. While some states have taxes on LLCs, the income flows through to the individual’s return avoiding double taxation.
If the partner is active in the business, they must pay self-employment taxes on their earnings. The company must also maintain separate books, and accounting costs are typically higher. An LLC must maintain its registration with the state to maintain liability protection.
The LLC entity structure is a good choice for companies with potential liability risks. This structure is relatively easy to navigate and provides substantial liability protection in most states.
S-Corp
S-corporations provide many of the benefits of a corporation while allowing the company’s income to be passed through to the owner and taxed at the owner’s personal income tax rate, thus avoiding double taxation.
S-Corps allow shareholders to avoid double taxation thanks to flow-through taxation. Furthermore, pass-through income gives additional flexibility to shareholders and opens more tax planning options. As a result, this structure can often minimize shareholders’ liability.
However, an S-corp must make any distributions equally based on ownership percentage, providing less flexibility for distributing company profits. Furthermore, S-Corps can have significant greater compliance requirements, and the number of shareholders in an S-Corp cannot exceed 100
The s-corporation structure works best for companies with significant possible liability exposure like medical practices, preschools, or restaurants and companies with only one owner.
C-Corp
Classic corporations typically organize themselves as C-Corps. In fact, most publicly traded companies fall under this designation.
C-corporations can have an unlimited number of shareholders, and each shareholder’s liability can’t exceed what they’ve invested in the company. C-corps can also organize their fiscal year according to their preferences because they aren’t bound to the calendar year.
The corporation stays separate from individual owners to maintain its status as a separate entity. The corporation must also satisfy regulatory requirements, including holding regular shareholder meetings and maintaining corporate records. Corporations can only pay cash to shareholders through compensated employment or dividend payments.
If your company hopes to go public one day, you should consider forming a C-Corp. Businesses with more than 100 shareholders may also find that a C-Corp structure is a good option.
Closing Thoughts
You should carefully consider your business’s circumstants before choosing an entity structure. Examining every aspect we discussed in this article to ensure you make the right choice.
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