Choosing the right business structure is key to ensuring long-term success when starting a business. Your business structure will affect everything from day-to-day operations to quarterly and annual reporting and taxes. It will also determine how much personal liability you have and how much your personal assets are at risk.
With the rise of social media, it seems everyone who has ever run a business has made countless videos extolling fix-all solutions or tax hacks that are quite literally too good to be true. The truth is choosing a business structure, especially for small businesses, will require a very personalized evaluation of your unique business and situation in order to ensure that the chosen structure offers the best mix of benefits and protection.
Business Structure Options
The simplest option is a sole proprietorship, where an individual owns and operates the business. This option comes with complete control, but no liability protection.
Another fairly simple structure is Partnerships, which involve two or more individuals or entities who share ownership, responsibilities, and profits. Partnerships can be general, with equal sharing of profits and liabilities, or limited, where the limited partner contributes capital but has limited liability.
Next, there are LLCs or Limited Liability Companies. An LLC is a flexible entity, allowing the owner(s) to move from a sole proprietorship to a partnership or S Corporation with ease. An LLC offers limited liability protection for owners (members) while allowing flexibility in management and taxation.
Finally, there are C Corps and S Corps. A C Corps is a separate legal entity owned by shareholders. C Corps have complex governance structures including a board of directors and officers.
S Corps are corporations that meet certain requirements and therefore gain a special tax designation allowing them to pass through income and losses to shareholders, avoiding double taxation.
There are other structures, but these are the most common.
Tax Implications
It’s critical to understand how your structure will result in your business being taxed.
Sole Props are taxed on the owners’ personal return, as are partnerships.
LLCs offer pass-through taxation, meaning the business’s profits and losses are “passed through” to the owners’ personal tax returns via a Schedule C. This can be great for small businesses and startups, due to avoiding double taxation at the corporation level.
C Corporations are subject to double taxation, meaning the corporation is taxed on its profits, and shareholders are also taxed on any dividends received. However, C Corps have the ability to retain earnings within the company which can lead to potential tax savings and investment opportunities.
S Corps provides pass-through taxation like LLCs, but have strict eligibility requirements. S Corps are limited to a certain number of shareholders, and all shareholders must be U.S. citizens or residents. This structure can be beneficial for small businesses seeking pass-through taxation and some of the liability protection of a corporation.
Liability Protection
With a sole proprietorship structure, the owner is personally liable in all business matters. Partnerships vary depending on if they are limited or general, as mentioned above.
Limited liability protection is a key feature of an LLC, hence the name. This means that the owner’s personal assets are generally protected from business liabilities and debts.
C Corps and S Corps also offer limited liability protection to shareholders, with corporate assets generally separate from the personal assets of its shareholders.
Ownership and Management Flexibility
Again, sole props are straightforward and generally owned and managed by one individual. Partnerships will typically have unique agreements for management and control based on if they are general or limited, and other factors, ultimately determined in the business agreement.
LLCs offer flexibility in ownership and management. There are no restrictions on the number or type of owners/members, and the members can choose to manage the business or appoint managers.
C Corps can have multiple classes of stock, which allows for different levels of ownership and financial rights. This flexibility can help attract investors and aid in structuring for ownership interests.
S Corps can only have one class of stock, and there are restrictions on the number and type of shareholders, which is not ideal if you will need to seek outside investment or have a complex ownership structure.
There are many other factors to consider, and it is very important to rely on individualized business advice provided by a qualified CPA or tax professional who understands your unique situation.
An in-depth breakdown by the US Small Business Administration can be found here. Learn more about Online Accounting and our services here.
