Starting a Business: What Business Entity Should I Choose?BondBeebe
Posting by Jacqueline Thompson, CPA
There are many decisions to be made when starting a business, not least of which is the business structure for your company. Your business structure will not only have legal implications, but also tax and operational consequences. To help you get started as you form your company, here is a list of common business structures, as well as the advantages and disadvantages of each type:
In this structure, you are the sole owner of the company. This structure is fairly straightforward, has few operational constraints, and no state filings are required to form your business. There is no separation between the proprietor (you, the business owner) and the business.
A sole proprietorship is the easiest and least expensive type of business to establish; there are few restrictions and it is easier to terminate. The biggest drawback with this type of business is exposure to liability. As the business owner, you are personally liable for any lawsuit filed against the business, and profits/losses are filed on your personal tax return.
If you anticipate pursuing funding, a sole proprietorship makes it difficult to raise capital, since you cannot sell stock in a sole proprietorship. Receiving bank loans can also be a challenge, as banks may question your ability to repay loans in the case of business failure.
Best for: Freelancers and self-employed individuals who do not anticipate hiring additional staff or a future business sale. Sole proprietorships are best when the level for potential liability or risk is low.
A partnership consists of two or more individuals who have agreed to share ownership of a business. Each partner contributes in all aspects of the business – financial, property, skills, etc. – and each partner shares in the profits and losses. Both partners are personally liable for the debts of the business.
There are several different types of partnership structures:
- General Partnership. Profits, liability, and management are divided equally among partners unless otherwise documented in the partnership agreement.
- Joint Ventures. These are a type of general partnership that is formed for a limited time or for a single project.
- Limited Partnership. This structure allows partners to have both limited liability as well as limited input, depending on the extent of each partner’s investment.
A partnership is an effective structure for pulling in other resources and business partners, and raising sufficient capital. However, these advantages can also cause problems, as coordinating with multiple partners can complicate decision-making efforts; we strongly recommend you enter into a comprehensive partnership agreement. It is also important to note that liability is still a concern with general partnerships and joint ventures.
Best for: A business owned and operated by several individuals with limited need for liability protection. This is a fairly tax-advantageous structure as the partnership itself is not taxed; the profits and losses pass through to the partners and are reported on the individual tax returns. If liability is a concern, a partnership may not be best. While a limited partnership does, indeed, limit liability, it may not be worth the sacrifice of limited involvement.
Corporation (C Corporation or C Corp)
A more complex business structure, this is formed as an independent legal entity that is owned by shareholders. The activity and scope of this type of business is restricted by a charter, and shareholders are protected from liability. A C Corporation is taxed separately from its owners, and both corporate profits and shareholder dividends are subject to federal tax.
Corporations are for more complex entities, so they can be time-consuming and costly, and have the most complex tax liabilities. They also require more nuanced tax planning to help address the double taxation aspect of this structure. However, they significantly limit liability and provide a solid foundation for creating a long-lasting business that will grow and bring on more employees over time.
Best for: Established businesses with employees whose owners have a need for significant liability protection. Corporations continue indefinitely, which is helpful for family businesses who hope to see their business last for multiple generations.
Limited Liability Company (LLC)
Often referred to as an LLC, a Limited Liability Company is a hybrid between a corporation and a partnership. An LLC limits liability while offering the income benefits of a partnership. In this structure, owners are referred to as “members;” an LLC can consist of only one, or two or more individuals/members.
LLCs are not taxed as separate entities. They provide pass-through income – the profits and losses are passed through to each member, and are then reported on the individual members’ personal federal tax returns.
Owners often form LLCs because they offer the most flexibility and they limit liability. However, their inherent flexibility mandates a more nuanced operating agreement, which should be created by a knowledgeable legal professional. Different states have different regulations regarding LLCs, which can also complicate membership and the lifespan of the company.
Best for: A company with multiple shareholders who need liability protection and cannot handle the tax complexities of a C Corp. An LLC will offer you and your business partners flexible management and distribution options. However, this may not be the best structure when looking to develop a long-lasting entity, as many states have regulations regarding the lifespan of LLCs.
Commonly referred to as an S Corp, this is a special type of corporation under the Subchapter S designation from the IRS. It differs from a C Corp because the business itself is not taxed – profits and losses can pass through to your personal tax return.
An S Corp provides significant tax benefits, as there are expense tax credits available. As it is structured separately from the shareholders, the business continues on as a legal entity separate from the owners and shares can be passed down to future generations. However, due to its special classification, an S-Corp has stricter operational processes and shareholder compensation requirements. While there is liability protection, it is limited.
Best for: Small businesses who want to structure the business as a separate legal entity, but avoid the taxes incurred by C-Corps. An S-Corp allows for business longevity, as it operates as a separate legal entity, and can be a good option for a family-owned business.
Choosing the right business structure is a complex decision, with many legal and financial consequences, and it should be done under the guidance of a trusted lawyer and CPA. Obtaining expert advice up front and looking to your future goals for the business will assist you in this choice and help you make the best decision for you and your company.