Starting a business can be difficult and can lead individuals to despair and confusion, not knowing where to start. Once you have identified the concept on which the business will be based, have created a business plan, and are ready to open the physical (or virtual) doors of operation, you will need to consider what type of entity you should deploy. There are various types of entities to choose from, all of which have some overlap with one another, but each of which have distinct advantages as well. You will want to determine what business structure fits your company and its vision best.
Hopefully, the succeeding information will be of benefit. Keep in mind that there may not be a right or wrong answer, and that over the course of a business’ life, priorities, goals, and the company’s focus can all change. This does not mean that you are stuck within the bounds of the structure chosen years ago, it can be altered over time- so you are not necessarily locked in (that said, it does not mean that certain tax implications may not be brought into play).
Disclaimer:
This should not be viewed as official business advice, it is highly recommended to consult your personal attorney and CPA before making any business decisions on this or other matters.
Sole Proprietorships
Sole Proprietorships are the easiest type of entity to form and are also the most common. With very few documents to submit and red tape to go through, it is a common structure for businesses just starting out. If you have started working, performing side hustles, contracted projects, or are providing freelance services and have not formed an entity, you are automatically considered a Sole Proprietor.
Set Up
Set Up generally consists of registering with your state, and typically your city and county and paying a few nominal fees.
Taxes
Sole Proprietorships are companies that are considered ‘one with the owner’, because the business is YOU. This means, from a tax perspective, your business is a ‘Flow Through Entity’. So, what does that mean? It essentially is saying that your earnings are only taxed once. You will utilize a Schedule C Form and provide it with your Form 1040 Individual Tax Returns each year you are in business. You will be taxed on the Net Earnings (Net Income) that your business produces and it is considered to be Ordinary Income. This income is the equivalent of having Gross Wages or a Salary for the year but you earned it through your business instead. Plus, if you lose money your first year or two, you can use the losses to offset other ordinary income that is taxable.
Be aware that you will have to pay a Self-Employment tax on your earnings. While working for a third party or company, you are already paying half of this tax (i.e., social security, Medicare), but your employer is paying for the other half. When you are self-employed you are the employer AND the employee, ultimately making you liable for both parts of the Social Security and Medicare taxes.
Exposure to Liability
Since your business is not legally considered separate from your persons, you personally carry the weight of the debts and liabilities assumed by your business. This means if your business defaults on its debt, or loses a lawsuit or has any other financial burden that hits it, your personal belongs can be at stake, not just your assets in the business. This risk may lead you to choose a different structure if you are in a business that has more added risk or likelihood of lawsuits than a typical industry. If, however you want to stick with this structure but are risk averse, you can potentially also purchase commercial insurance to cover you concerning lawsuits, however, this will not likely encompass any debts.
Ownership and Partners
A Sole Proprietorship is exactly how it sounds, one sole owner. If you are looking to have a partner or second owner, this will disqualify you for use this business structure. This structure is very restrictive in this nature but does allow you to let you spouse/partner perform some work with you without changing.
Other
A couple other items to consider when contemplating using the Sole Proprietorship method is if you want to have a business name other than your own. To use and protect your name you can file for an “Assumed Name” or “Doing Business As” (DBA) designation, which can give some protection for the name until you decide to utilize a more formal business structure and register with your state.
A disadvantage to having a sole proprietorship is that you cannot build business credit. Bank accounts, Credit Cards and loans are all taken underneath the individual / owners name, so if you want to start building business credit early, a different avenue may be more appealing.
Partnerships
A Partnership is very similar to the Sole Proprietorship, but hence in the name, you have partners so there is more than one owner.
Set Up
Set Up generally consists of registering with your state, and typically your city and county and paying some nominal fees. Although it is not required to have a formal written partnership agreement in place, it is highly advisable so that governance, how the company is to operate, profit sharing, and future plans of dissolution are documented.
Taxes
Taxes for a partnership are very similar to ones of a sole proprietorship. Partnerships are also considered to be ‘Pass-Through-Entities’ and the income will only be taxed once at the individual level as Ordinary Income.
Exposure to Liability
There are several types of partnership structures which may vary the exposure of liability each partner will assume. A regular general partnership makes the partners assume liabilities of the business similar to a Sole Proprietorship, where the partners individual personal belongings/assets can become at risk. With a general partnership, all of the partners have authority to enter in agreements that are assumed by the other partners as well.
There are Partnerships that have ‘General’ and ‘Limited’ Partners which can partially eliminate that issue. The general partners will be the operators of the business and can still execute documents on behalf of the company but Limited Partners are much more restricted. Limited Partners are not responsible for the day-to-day running of the business and do not have the same rights to make decisions. As a result, they are essentially investors and their losses are limited, to only to the amount they have put up in their investment.
The final Partnership to discuss is a Limited Liability Partnership (LLP). This is a partnership which limits the liability of each partner related to certain malpractice and lawsuits to specific partner(s). This does not put someone at risk from a liability standpoint for the acts of other partners acts of noncompliance. Most of these partnerships are in the area of professional services. Some states have restrictions that limit the use these types of partnerships to certain businesses.
Ownership and Partners
For this entity it is a requirement to have at least two or more individuals owning the entity. For General Partnerships there is no restriction on who can be a partner thus you can have Corporations and LLCs enter into these partnership agreements as well.
Other
There are a couple other items to mention when contemplating using the Partnership structure. If you want to have an alternative business name or brand name, you can establish an “Assumed Name” or Doing Business As (DBA) name which can give some protection for the brand or name until you decide to utilize a more formal business structure and register formally within your state.
Same as the sole proprietor option, a disadvantage to having a Partnership is that you cannot build business credit. Bank accounts and Credit Cards and loans are all established underneath the individuals name, so if you want to start building business credit early, a different avenue may be more appealing.
LLC
The LLC is a newer form of entity designed to provide limited liability to investors while still having advantageous tax optionality.
Set Up
The set-up process has additional costs compared to the Sole Proprietor and Partnership and involves more filing / registration /paperwork to establish an LLC, depending on the state. Other additional costs may come up for this structure as some states require fees based on the number of LLC members.
Taxes
LLCs are unique from the perspective that members of the LLC elect to be taxed as a ‘Flow Through Entity’ similar to a partnership or can elect to be taxed as a C Corp (which will be covered below).
Exposure to Liability
The LLC framework offers the opportunity to limit liability to the assets within the company (unless you personally guarantee a loan), hence from the name ‘Limited Liability Company’. Similar to a partnership, owners/members each have a right to establish governance guidelines authorizing them to enter into agreements and act as agents for the company, so while you will be limited to losing only the amount that is put into the company, you still have that amount at risk.
Also similar to partnerships, you can have a Manager Managed LLC where a smaller group of Members within the LLC are the agents and can manage operations of the company. The others are passive members of the company.
Ownership and Partners
Owners and investors of LLCs are considered ‘Members’. An individual or an entity can be a Member of an LLC including Corps, trusts, and other LLCs. Individuals generally have to be at least 18 years of age but do not necessarily have to be a US citizen. There is no maximum on number of members and most states allow ‘single-member’ LLCs.
One downside of an LLC is that you cannot have multiple types of members like in a C Corporation which can have different shareholders with different rights and voting privileges. However, there is some optionality regarding allocation of profits. The allocation of profits does not necessarily have to be proportional as a member owning 50% of the entity may have rights to 75% of the profits/losses, if other LLC members are in agreement.
S Corps
The S Corp is the step-brother of an LLC, it is the original entity which provided Limited Liability and was taxed a flow-through entity. It does however have more red tape and more hoops may have to be jumped through to create and operate under this structure.
Set Up
Similar to LLCs, you will need to register with your state as well as file annual reports.
Taxes
S Corps are taxed along the same lines as a Partnership, considered as a Flow Through Entity. Once again, this means that you will be taxed Ordinary Income on the Income earned in the entity.
One benefit of the S Corp is that you may be able to minimize you Self Employment Taxes paid. This can be done when you pay yourself a ‘reasonable’ salary through a W-2 and then the remaining amount is considered to be Net Income for the entity which is subsequently distributed and ends ups as Other ‘Non-Passive’ Income on your Individual Tax Return. You will only be subject to the Self Employment Taxes on the amount paid in salary and wages. However, it should be recognized that the IRS is very familiar with this and tracks it closely requiring reasonable ‘market level’ salaries be paid.
Exposure to Liability
S Corporations may provide shareholders shelter for liabilities that the company incurred. Debts or loses from a lawsuit can only obtained from the company’s assets and the company’s assets and obligations are considered separate from its’ shareholders.
Ownership and Partners
S Corps have much more restrictive ownerships rules and regulations to adhere to. You are considered a ‘shareholder’ if you own part of an S Corp. S Corporations can have as few as 1 shareholder and up to 100 shareholders, all of which have to be US citizens. Additionally, each shareholder must be an individual, thus other S Corps, C Corps, LLCs, and partnerships cannot be owners of an S Corp. Allocation of Profit and Loss is also directly correlated to % ownership of the company. This is inflexible compared to an LLC, which, if agreed by their members, can choose different payouts to their owners.
Also, there are additional regulations affecting S Corps, such as having Board of Directors meetings, Shareholder’s meetings, and other corporate meetings, all of which need to be documented.
C Corps
Set Up
The set-up process has additional costs compared to the Sole Proprietor and Partnership and involves more filing / registration /paperwork to establish an C Corp, depending on the state.
Taxes
Taxes for C Corps are one of the biggest differentiators compared to other entities and legal structures. With a C Corp, it is considered a separate legal entity than its owners/shareholders, and is also taxed separately for the income it generates (with the ability to deduct salaries and wages). So, owners of the company who invest and want to see a return on their investment must be prepared to pay for it through ‘double taxation’. This double taxation comes once at the Corporation level where Net Income for the business is taxed at a certain percentage, and then a second time when dividends are disbursed to the owners. The second tax can be deferred by not having dividends paid out to the owners and having that money kept in the company for growth purposes, but then you will also see appreciation in your stock basis (price per share) and when you sell it will have to pay the capital gain related to the sale.
Exposure to Liability
As with S Corps, C Corporations may provide shelter for liabilities that the company has incurred, so any debts or loses from a lawsuit can only come from the company’s asset and the company’s assets and obligations are separate from those of the shareholders.
Ownership and Partners
Besides the limited liability (which can also potentially be achieved through an S Corp or LLC), the freedom on ownership and partners/investors flexibility within a C Corporation is the main attraction to choose this structure. There is no limit on the number of investors/shareholders for a C Corp and these shareholders can also be Non-US Citizens or other business entities such as C Corps, S Corps, LLCs.
Another Advantage is that C Corps can issue more than one type of stock, each with different investor and voting rights, as well as provide different dividend/distribution amounts and preferences.
C Corps double taxation results in potentially higher taxes, but the structure also provides much more flexibility and optionality related to ownerships levels, which depending on your size company, may or may not be worth it.
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