So you made the difficult decision to start your own business! Now you need to choose the best business structure to meet your needs.
It’s a difficult decision to start your own business because unlike getting a job, there is little structure around what you should be doing with your time.
How you run your business, when you get things done, and how you measure success are all up to you.
That type of framework (or lack of) can be somewhat overwhelming, especially if you apply it to ALL aspects of your business.
A Brief Overview of Business Entity Types
Thinking deeply about your business before taking action is so necessary to aligning your vision to goals and also the strategies to achieve those goals.
Part of this business plan is deciding what kind of business entity you want to classify your business.
You may have already heard of these, but just as a reminder, there are four types of business entities:
- Sole Proprietors
- Partnerships
- Corporations
- LLCs.
Each of them has tax and legal implications, and the legal implications can vary a little from state to state. Picking one of these will depend on what your ultimate goal for your business will be.
Let's take a look at each business structure in more detail.
Sole Proprietor
As the name suggests, a sole proprietor only works if the business has one owner.
To start, we don’t recommend ever keeping your business as a sole proprietor. Being a sole proprietor means you just started operating your business without registering with your Secretary of State or forming an operating agreement for your business.
The main downside of the Sole Proprietor is that you have unlimited personal liability from your business. For example, say you’re mowing someone’s lawn and accidentally fling a rock into the owner’s head. The owner can sue you personally, and all of your personal assets (home, car, etc.) will be at risk.
You might be okay operating as a sole proprietor if you’re trying out the business to make sure you enjoy doing it. If you are thinking of starting a lawn mowing business, you might begin by asking neighbors if they’d be willing to let you mow their lawn for money.
If you enjoy it, you can register your business as one of the entities mentioned below. If you don’t enjoy it, you can stop doing it without having to worry about dissolving the company.
Partnerships
Partnerships are businesses that run with at least two people or entities.
Partnerships allow partners to join and leave the partnership, and their share of the profits and loss of the business can be flexible.
For instance, partners A and B formed a partnership where A contributed 90% of the capital and B contributed 10% of the capital. Their share of the profits and loss can still be 50%-50% because B might have some fundamental knowledge that is vital to the success of the business.
General partners in a partnership will have unlimited personal liability like a sole proprietor. They will also be liable for their partner’s actions.
In the example above, let’s say A and B formed a partnership and then a couple of years later, they applied for a $750,000 business loan. Once they receive the cash, B takes it and flees to South America never to be heard from again.
Partner A will be liable for that $750,000 due to unlimited personal liability, and his personal assets will be at risk.
There are Limited Liability Partnerships (LLP) that can be used to prevent this from happening. In an LLP, the partners are only liable for what they invested in the business, and the banks can’t go after their personal assets to recover any losses.
A few other items to keep in mind about partnerships:
- If all partners sell their interest to one partner, the partnership must terminate because there is no longer at least two partners.
- If more than 50% of the partnership interests are exchanged during a 1-year timeframe, the partnership must terminate, and a new partnership must be formed.
- It is crucial to get a partnership agreement drafted by an attorney.
Corporations
Corporations are business entities that have stock that owners can purchase to own a share of the company.
Corporations have stringent corporate formalities by which they must operate. For example, if you form a corporation, you must have regular shareholder meetings and board of director meetings, while keeping minutes of these meetings on record.
It’s also imperative to have a stock ledger with stock certificates, so when you issue shares to yourself or other owners, you have a record of it.
There are two types of corporations: S corporations and C Corporations.
S Corporations
S Corporations are corporations that are ideal for smaller businesses. They are limited to 100 different shareholders, and the shareholders must be domestic persons or entities.
S Corporations are somewhat restricted in terms of ownership and how they operate, but they do provide one significant benefit.
Owners of S Corporations do not pay Self Employment tax on their earnings, which is around a 15% savings in taxes. There are some minor complications to be aware of for that, but that is a major saving to consider.
Distributions and income paid out to its owners must be paid out on a pro-rata basis. So unlike Partnerships, your ownership percentage in an S Corporation determines how much income you report with no flexibility there.
C Corporations
C Corporations are corporations that are ideal for larger businesses looking to gain capital quickly.
There are no restrictions on who can own C Corporation stock. Since stock is relatively easy to buy and sell, it is also very simple to gain investors for your business.
C Corporations also pay their taxes as a separate entity at the corporate tax rate, which was reduced to 21% in 2018. That’s a reasonably low tax rate!
However, owners who wish to take money out of the company as dividends must also pay taxes on the dividends.
So essentially, you are taxed twice. Once on a corporate level and once on a personal level.
Limited Liability Companies
LLCs are the most flexible of all of the business entities. Depending on the state, there might not be any formalities the LLC has to follow to operate.
You define how your LLC operates in the operating agreement that your attorney drafts. LLCs have limited liability, so any owners of the LLC are not personally liable for any of the company’s dealings.
Any person or entity can have an ownership interest in an LLC, and there is no limit on the number of people or entities who can have an ownership interest in the LLC.
With an LLC, multiple levels of distributions can be paid out to owners, and ownership interest doesn’t have to equal the share in profits and losses.
The IRS doesn’t recognize an LLC as a taxable entity, so the way that LLCs file taxes depends on several factors.
If the LLC has one member, then by default, it will file taxes as a sole proprietor. If the LLC has more than one member, then by default, it will file taxes as a Partnership.
However, an LLC can elect to be taxed as a Corporation. Even better, the LLC can choose to be taxed as an S Corporation, which provides the benefits of not paying self-employment taxes and not having strict corporate formalities to follow.
Since S Corporations have ownership restrictions, an LLC that elects to be taxed as an S Corp has to comply with those restrictions to qualify.
Final Thoughts
Choosing the right business entity for you can be overwhelming, and it depends on the long term goals of your business. However, most smaller companies just starting will elect as an LLC and if it makes sense, to have those LLCs file taxes as an S Corporation.
Another common misconception is that once a person forms an LLC, Corporation, or LLP, they are entirely immune from personal liability due to liability protection. For liability protection to be fully supported, a document outlining how the business operates is essential for the court of law in litigation.
For an LLC, this is called an Operating Agreement, Corporations use Corporate Bylaws, and LLPs use Partnership Agreements. An attorney should draft these documents for you.
If your business ever runs into trouble, the courts will verify that your business operates according to the documents.
Please note, everyone’s situation is slightly different. You should consult your accountant and attorney before making your final decision of which business entity will work best for you.
About Our Guest Author
CPA
Ryan Nguyen
Ryan Nguyen is the owner of Nguyen & Associates, a CPA firm that he started in 2015. He thought he made a terrible decision of picking accounting as a career path until he started his firm and started seeing how his clients can pay themselves more through his help.
Taxes and accounting don't have to be burdensome and overwhelming, and he's passionate about encouraging people to feel relief and safe around those areas. Since he started his company, he's helped over 200 businesses and over 400 individuals.
Header image courtesy of Pexels.