When you start a business, the structure you choose for your company is a key decision. Your structure affects your day-to-day operations. The form of business you decide on affects your liability, personal tax returns, and the administrative work you’re responsible for.
Every business structure has its own pros and cons, and the following are seven things to know.
1. What is a Business Formation?
A business formation is also known as a legal or business structure. You need to choose your business structure before you register your business in your state.
Businesses will also usually have to get a tax ID number and make sure they file for any needed licenses and permits. You can change your business structure in the future, but there can be restrictions and tax consequences, so it’s best to take your time and choose the right one initially.
2. You Don’t Necessarily Need an Attorney
You don’t have to get an attorney to form a business, although depending on your needs, it can be smart to consult with one. A business attorney can advise you on the best business entity type for you during the formation process.
Then, you’ll be assured you’re going to meet all the requirements for formation. You will have to complete and file paperwork, and this paperwork can be complex, including operating agreements, partnerships, and shareholder agreements.
3. Sole Proprietorship
A sole proprietorship is easy to form, and when you go with this option, you retain complete control of your business. You’re automatically considered a sole proprietorship if you do business activities, but you don’t take steps to register as any other kind.
You don’t actually produce a separate business entity in this situation. The issue here is that your business assets and liabilities aren’t separated from one another. You can, as a result, be held personally liable for debts and obligations of your business. If you’re a sole proprietor, you can still get a trade name, but you can’t sell stock, plus banks are reluctant to lend to sole proprietorships.
What you might do is use a sole proprietorship if you want to test a business idea and then form a formal business later when you’re ready.
4. Limited Liability Company
A limited liability company or LLC allows you to take advantage of the benefits of partnership business structures. One reason that you might opt for an LLC is that it provides your personal assets some protection. If your business were to face a lawsuit or bankruptcy, your house, savings and vehicle wouldn’t usually be at risk.
Your profits and losses are passed through to your personal income, and you don’t have to deal with corporate taxes. At the same time, if you’re part of an LLC, you’re considered self-employed, so you have to pay self-employment tax contributions toward Social Security and Medicare.
If you have a medium or high-risk business, and you want to protect your personal assets while paying a lower tax rate than with a corporation, an LLC might be an option.
5. Partnerships
A partnership is a simple way for two or more people to own a business together. There are two typical types of partnerships—limited partnerships and limited liability partnerships.
A limited partnership has one partner with unlimited liability, and the others have limited liability.
The partners with limited liability have limited company control, which is outlined in a partnership agreement.
Limited liability partnerships provide limited liability to all the partners.
6. Corporations
There are several types of corporations. One is a C corporation or C corp. This entity is separate from its owners. A corporation can make a profit, be held legally liable, and be taxed.
Corporations provide a business owner with the strongest personal liability, but it’s more expensive to form a C corp than other types of businesses. If you form a corporation, you’re also responsible for more administrative work and record-keeping, and there’s a lot of reporting that has to be done.
Corporations pay income tax on profits, which is a difference between these structures and sole proprietorships, partnerships, and LLCs. Sometimes corporate profits can be taxed twice. They can be taxed when the company makes a profit and again when shareholders are paid dividends on their personal tax returns.
If a shareholder leaves the company or sells their shares, the C corp can carry on largely undisturbed since corporates have identities fully separate from owners.
One benefit of a corporation is that it helps with raising capital. An S corporation or S corp is designed to prevent the double-taxation downsides of a C corp. S corps allow for profits and some losses to pass through directly to the owners’ personal income, and they aren’t subject to corporate tax rates.
Not all states handle the taxation of S corps equally, but most do recognize them the same as the federal government, taxing shareholders accordingly.
There are limits on S corps, and you have to check with the IRS to determine how these could affect you. An S corp, like a C corp, has an independent life of its own.
A benefit corporation, also known as a B Corp, is a for-profit corporation that’s recognized in most states. They aren’t different from C corps in how they’re taxed, but they are different in terms of purpose, transparency, and accountability.
Both mission and profit drive B corps. Some B Corps have to submit annual reports that show they’re contributing to the greater public good.
7. Combining Structures
Things like an S corp aren’t strictly a business structure—it’s also a tax status. So, an LLC could be taxed as a nonprofit or S corp, for example. This isn’t common, and these situations become more complex to set up. If you want a non-standard structure or you’re thinking about it, it’s a good idea to talk to an attorney first.
It’s also important to remember that while business structures are generally comparable across states, rules, taxes, filing requirements, and liability can vary somewhat depending on where you live.