Are you starting a new business? Not sure where to begin when it comes to legally setting up the type of business entity you desire? First, it is important to understand the Differences between Business Types and what would matter most for your company. Depending on which business type you choose will have a large influence on all of your business operations, from personal liability to taxes and accounting. Let’s dig in to the 5 main different types of business structures and how to choose the right one for you.
Sole Proprietorship
This type of business is primarily the simplest, easiest and least expensive type of business to create. Typically, you don’t have to register your business with the state. However, it may be required locally by obtaining a business license or permit.
Sole Proprietorships have unlimited liability and only have one owner. This means they are solely responsible for all business activity, including debt. The business owner and the business are one in the same if the owner names their business something other than their own legal name. This makes filing taxes much easier, as these types of business are considered “pass-through entities”, meaning all profits are passed through to the business owner and claimed on their personal tax returns.
However, this also means that you are personally on the hook for any debt, liabilities or legal claims that may be made against your business. There is no personal liability protection. That means you may even be held responsible for your employees’ actions while they are on the job.
Raising money for a Sole Proprietorship can also be difficult. There is no stock to sell or set percentages to offer, which makes banks more reluctant to offer loans or financing. You may need to depend on your own sources, such as savings, home equity or personal credit.
This type of business may be a great way for a business to start out, but an owner may choose to expand into a corporation or LLC as the business grows. It’s perfect for a low-risk business that want their business idea tested before forming a more formal business structure.
Partnership
This type of business entity allows for two or more people to start a business together and is the easiest way to do so. Each owner has an equal stake and shared liabilities. It’s a great way to start a business, as you can pool resources and knowledge with another. They also may or may not need to register with the state they do business in, depending on where they live. There are two types of partnerships, which are explained below:
-
General Partnerships
This implies that all business partners have equal authority, meaning any partner can make legal decisions and contribute to daily operations. Usually, profits and losses are also split equally.
-
Limited Partnerships
This implies that partners do not have an equal say in the business. The main partner has a say in daily operations, while the limited partner, or “silent partner”, does not. What a limited partner is allowed to do is typically documented in a partnership agreement (and they are usually just investors only).
Profits pass-through to each partners’ personal tax return, just like with sole proprietorships. This type of business structure is a good choice for businesses with multiple owners and professional groups (like attorneys or doctors).
It’s also imperative to create a partnership agreement in the beginning of creating your business. While it may seem hard to answer these questions when you’re excited and couldn’t imagine not getting along with your business partner, it will help to avoid legal fees and to protect yourself if you do have one. Things to make sure you are on the same page with as your partner:
- What is each partner’s investment?
- What are the responsibilities and duties of each partner?
- If the partner becomes disabled, how long will they get a share of the profits?
- What will you do if one partner wants to withdraw?
- How will conflicts be resolved?
These are important items to consider, as selling a business can be extremely difficult in a partnership and it’s best to outline what will happen now if someone decides to leave.
LLC
These types of organizations combine features of a corporation with those of sole proprietorships and partnerships. Laws vary by state for LLCs, but the basic structure is the same everywhere. Owners of LLC’s have limited liability, but they are also pass-through entities like partnerships, which makes them a less formal business structure than corporations. No matter how many members an LLC has, however, there must be a managing member who takes care of daily business operations.
A board of directors is not required, and it is better for maximum flexibility in how you manage and run your business. Unlimited owners are allowed, and you are NOT personally on the hook for any business liabilities that accrue. You can also be taxed once or twice. You can choose which would work best for you to help minimize taxes. LLC members also cannot pay themselves ordinary wages, so whether a member’s share of the profits is distributed to them, that share will represent their taxable income.
It’s also important to know that members of an LLC are considered self-employed, so they must pay self-employment tax contributions towards items like Medicare and Social Security.
It is necessary to file ongoing documents and pay regular fees in order to stay in compliance and LLCs also cannot go public. But LLC’s have far less paperwork than corporations. There are fewer requirements regarding resolutions and meetings, but it is something to consider. It’s a great choice for medium or higher-risk businesses, owners with significant personal assets they want to protect and for owners who want to pay a lower tax rate than they would in a corporation.
Corporation
This is a common business structure many people are familiar with. One of the first steps is to incorporate your business with changes to this process depending on which state you live in. You would also need to set up bylaws that describe in detail how the corporation will run. This includes the responsibilities of shareholders, directors and officers, when meetings will be held, and other details that are necessary to run the business. There are different types of corporates, primarily C corps and S corps. Learn more about their differences below:
-
C corp
These are separate legal entities from their owners. The owners have limited liability, and their personal assets are not at risk if the company fails or is sued. Owners of C corps must legally incorporate their business in their state, which allows shareholders to hold stock in the company. Shareholders then elect a board of directors who are responsible to help guide business decisions in the company, so there can be less management flexibility within the business.
These are the only types of business structures that are subject to corporate income taxes. As a result, this subjects C corps to double taxation. This makes them a better choice for larger companies. Corporate income tax is first paid on income, and then both stockholder distributions. Shareholder income are taxed on the personal tax returns of these individuals.
C corps are a good business structure option for companies who plan to go public one day. They can issue shares to founders, employees and investors. It’s also recognized internationally with preferred stock options. They do, however, have a lot of formalities with a board of directors, official meetings and annual reports that need to be created. It can make them slow and cumbersome to operate but is still the preferred method of corporation available for many.
-
S corp
These have certain limitations. They are perfect for smaller corporations that are just starting out. They can only have up to 100 shareholders (who must be citizens or residents of the U.S.) and they can only have common stock. Unlike C corps, S corps are considered pass-through entities. This means the business owner is not on the hook for business liabilities. Shareholders only pay on profits received. Items are only taxed once.
S corps also have less management flexibility and must have a board of directors. And there is more admin and strict rules about holding meetings and keeping records. Ongoing filings and fees are also required in order to stay in compliance.
An S corp may also run the risk of greater scrutiny from the IRS at tax time, as some business owners have attempted to pay themselves low wages in the past and take big dividend distributions instead, in order to save money on taxes. You’ll want to make sure you document any reasons why you would do this if you go this route.
If you are starting out and are a smaller business, especially an online business, declaring your business as a corporation may not be your best option. If you already have a larger, established business, though, with several employees, moving to a corporate business type may be appropriate.
Non-Profit
These are technically considered corporations. They are required to file articles of incorporation within the state they are registering in. However, it’s unique because they are considered non-business entities. Their purpose is not to earn a profit. Generally, non-profits are dedicated to serving a particular charitable mission or cause. They are exempt from paying federal income taxes because they are claiming the 501(c) status with the IRS.
This is a great way to support a good cause. However, you also want to protect your personal assets. They are typically organized to do charity, education, religious, literary or scientific work. Two main types are public charities and foundations.
Public charities receive donations for funding a specific mission direction. These donations come from individuals or grants from either foundations or the government. Foundations, on the other hand, are typically established with a sum of money from a single source, like a family. This foundation would than provide grants to public charities that serve a purpose in line with their goals.
Non-profits do have a board of directors, but they do not have shareholders. Any profit that goes back into the organization is used to serve its mission. While there is not an owner, per se, an individual can start or oversee a nonprofit. They can help to find additional donors.
Make sure you choose a business structure that gives you the right balance of legal protections and benefits. It’s not a decision to be entered into lightly. It should be made with sound counsel from business experts.
And please note that any changes in company type must be done by March 15th. If you have questions, please reach out to us here or give us a call at 608-225-4350.