One of the first questions to answer as an entrepreneur and new business owner is what structure is best for your new business. There are a few options and the differences can make a substantial impact on your company. The four most popular structures are Sole Proprietorships, Partnerships, Corporations, and Limited Liability Companies (LLCs). Each business structure has strengths and weaknesses, so it is important to determine which entity type is best for you.
Sole Proprietors
Arguably the easiest business structure is a Sole Proprietorship. The company is owned by one person, who is called the sole proprietor. In the eyes of the government, the business and the owner are indistinguishable from tax and legal perspective. The fees are generally minimal, and the paperwork is usually pretty easy. The owner has complete control of the company and complete access to all business profits.
The main drawback is liability protection or lack thereof. Sole Proprietors are legally responsible for all debts and obligations both on the business and personal side. Since the owner and the company are viewed as the same, a Sole Proprietor could be forced to give up personal assets to pay off business debt, for example.
The tax process is relatively easy as well. All taxes related to the business are filed on the owner’s individual tax return. As a newfound business owner, you will have to include self-employment taxes in your tax returns, on top of any other personal taxes your family generates. This process is much easier than filing a business tax return, and there are no W2s or K1s to deal with.
Partnerships
The partnership entity is the first step into a more complex business structure. Primarily because instead of one sole owner, there are two or more partners who own the company. Once multiple people are introduced, documents like a Partnership Agreement become important. This agreement will outline the rules of the company and explain the breakdown in ownership, management, profits, voting, and more.
The importance of liability increases as more people are introduced as well. There are a few types of partnerships to consider when it comes to liability protection. The general partnership is the most common, where all partners share the business and remain liable for all business debts. Limited partnerships allow certain partners to step back from activities and management of the business in exchange for liability protection. While they are still owners, limited partners are generally only liable to the extent of their investment in the company. The general partners still fully operate the company and therefore are still fully liable.
Partnerships also require a business tax return, specifically the US Return of Partnership Income form. Even though you technically file a business tax return, partnerships are still one of many structures that are considered “pass-through entities”. In other words, the business income, profits, and taxes pass through from the company to the personal owners. To do this successfully, the partnership provides each partner with a K1 form for their personal tax returns.
Corporations
To fully separate yourself from any pass-through status, structuring the business as a corporation is by far the most common. While there are different types of corporations, the main theme is the business has its own identity. The corporation, from a tax and legal perspective, is an active “person” who can have beliefs, pay taxes, get sued, hire employees, and more. As a result, owners of a corporation are generally not responsible for the obligations of the corporation. However, the added liability protection does come with additional costs.
Corporations have to file a corporate tax return and therefore have to pay corporate income tax. Currently, there is a 21% income tax rate due on the company level before distributing any profits to the owners. This is when “Double Taxation” kicks in, where the same dollar is taxed once on the corporate level and a second time on the owner’s personal income taxes, usually either as ordinary income or dividend income.
For many small business owners, the normal corporate structure (commonly known as a C Corp) can be overkill and too expensive to set up and administer. So many file as an S corporation where businesses keep the benefits of a separate entity but use the pass-through status of income similar to the partnership. There are certain rules to adhere to, but the S Corp can be a great structure to bridge the gap between a partnership and a major corporation.
Limited Liability Companies
Finally, limited liability companies (LLCs) are another common business structure. It almost seems like LLCs are synonymous with new businesses. Interestingly though, LLCs were only invented back in the 1970s in Wyoming. Compared to the older models, they are still a relatively new way to structure your business. The reason they are so popular is mainly because they split the tax and legal perspectives entirely.
As the name implies, an LLC limits the liability of the owner’s assets from the business. From a legal perspective, owners can get the benefits of a sole proprietorship or partnership without the risk to their personal life and assets. Many partners are set up as a Partnership LLC for this reason, to remove the risk of their partner defaulting on them while still going into business together.
From a tax perspective, the LLC structure itself is not recognized by the IRS. That is why LLCs have the option of how to structure their tax setup. Electing to be taxed as a partnership or corporation could have different results, depending on what you want for your company. Some states even require professionals to create a “Professional LLC” (PLLC), which is similar to a Sole Proprietor wrapped inside the LLC. Work with your accountant to understand the implications of each tax status to determine which is right for your situation.
Which Structure is Right for You?
Deciding on the right business structure is an important start to any start-up. Usually, the number of owners in the mix is the easiest indication. As multiple people are introduced to the owner’s circle, the complexity increases. Focus not just on how you want the business to run, but also the legal and tax consequences of your actions. With any luck, the right business structure could save you money and help your business grow.
TC Falkner 