How to Determine the Legal Structure of Your Business
Most small businesses start as sole proprietors or partnerships, then, as they grow, set up a Limited Liability Company (LLC) or a Corporation to help protect them from business liability.
While protection from liability is a great reason to create or change corporate structure, choosing the right business identity can create tax advantages, too. Even if operating as a sole proprietorship made perfect sense at one point, that structure may no longer be as effective once your business has grown and may keep you from reducing your taxes to the fullest extent.
The following is an overview of the different types of corporate structure. Use this information as general guidance; always consult an accounting or legal professional for advice specific to your individual situation.
In legal terms it's easy to start a company. If you start a business, your firm is considered by default a sole proprietorship or partnership unless formally create another legal entity.
For example, if you take on consulting jobs as a way to generate additional income, that consulting business is considered a sole proprietorship. If you don't set up another legal entity the business is not considered "distinct and separate" from you; you are the business and report the income you generate on your personal tax return.
A sole proprietorship is a simple way to start and operate a business but it also has drawbacks. Since you "are the business" you carry unlimited liability for any business debts. If you're sued, the result may not just cost you the company but everything else you own as well. And you may miss out on significant tax advantages.
If you want to limit your liability in other words, limit your liability to what you have invested in the company you can set up an LLC or a corporation. (But keep in mind creditors may be able to "pierce the corporate veil" in cases of fraud or when legal and reporting requirements haven't been met. As long as you operate by the book that should not be a concern.) A corporate structure can also provide a number of tax advantages.
In those cases setting up a corporation can be a great decision. Failing to do so is a very common mistake made by small business owners.
Let's look at the options available.
Sole Proprietorship & Partnership
A proprietorship is the simplest but also the riskiest form of ownership. Very little paperwork is necessary and taxes are filed as part of your personal tax return. In most cases all you'll need to get started is a business license. Those are the positives; on the other hand, all your business and personal assets could be at risk in the case of loss or liability.
A partnership works the same way; the only difference is partnerships are operated by two or more people. General partners share in profits and are personally responsible for any losses or liabilities. Limited partners invest in the business, but agree not to participate in business decisions and as a result limit their exposure to loss or liability. (In simplest terms, think of a limited partner as a "silent partner.")
The main benefit for sole proprietorships and partnerships is pass-through taxation. The business does not file income taxes; all income, losses, deductions, and credits pass through to the owners and are filed on their personal tax returns. But and this is a major "but" owners and partners face personal responsibility for loss or liability. Additionally, owners can miss out on tax breaks and company benefit programs like insurance and retirement plans.
Limited Liability Company
An LLC blends the structure of a partnership with the liability protection given to Corporations. Many experts advise small business owners to form LLCs because a Limited Liability Company is relatively easy to set up and provides a fair amount of flexibility and protection.
An LLC functions in some ways like a partnership because the profits "pass through" to the owner's tax return. Losses can be used to offset other income, but only up to the amount invested. (In other words, you can not use a small investment in an LLC to shelter a significant amount of other income.)
A corporation is a separate and distinct legal entity. Someone can sue a corporation. While that doesn't sound positive, it does mean owners are protected from liability, because while you may own the corporation the corporation exists separately from you. Corporations are created, registered, and operated under the laws of the state where their articles of incorporation were filed.
Owners of corporations are considered shareholders and enjoy several key benefits:
- Employees (or even just yourself if you're the only employee) can participate in company-paid benefit plans health insurance, retirement plans, etc.
- Lawsuits are filed against the company instead of individuals (except in cases of criminal or discriminatory behavior), protecting employees and their assets from personal liability.
- Losses and debts are the responsibility of the company and not of individual employees; only company assets can be used to take care of company obligations.
Most corporations are set up as Subchapter C Corporations. A C-Corp (what accountants and lawyers call the standard corporation) has shares that can be freely traded among an unlimited number of owners, which makes it a great vehicle for a small company about to go public. A C-Corp files its own tax return and distributes any profits to the owners. Those profits are in effect "double-taxed" since the corporation pays taxes on profits first and then the owner pays taxes, in the form of income tax, on any distributions. (Keep in mind that "profits" can be distributed as wages, which avoids the issue of double taxation.)
A Subchapter S corporation operates in a similar fashion with one main difference: Company income can "pass through" to owners just like in a sole proprietorship. As a result, income flows through to individual shareholders and taxes are paid at the owner level, not the corporate level. Many people who are the sole owners and employees of their company like consultants and real estate agents set up S-Corps to enjoy pass-through income, avoid self-employment tax, and receive protection from liability.
Which form of business ownership is right for you? If you're just getting started, a sole proprietorship or partnership is the simplest way to dip your toe in the business waters.
As your business becomes more established or if you're concerned about personal liability, set up an LLC or a C-Corp.
And if you want income to pass through to your personal tax return, set up an S-Corp.
But before you make a final decision, talk to accounting and legal professionals to get specific advice for your individual situation and needs.