You are ready to start a business and need to decide “What business structure should I choose?”. Below is a list of factors to consider in selecting your business structure, as you narrow down what is important to you now and what could be important to you later. Please feel free to print this out and use a highlighter to dissect each business to see which fits you in the best way
Sole Proprietorship
- One owner
- Least complex/costly. No need to register with the state or prepare an operating agreement (but don’t forget the need for local registration for permit or license)
- Record keeping and reporting are minimal as really only need good financial records for tax purposes.
- Income taxes are paid through the owner’s individual 1040 with a Schedule C
- The owner is considered self-employed and therefore is required to pay estimated taxes quarterly and pay self-employment taxes (Social Security and Medicare)
- Business is easily ended by the owner’s choosing or death.
- Owner and business are not separate entities so the owner receives all the profits, bears all the losses, and carries all the liabilities of the business.
- Transfer of business is simple if not registered with the state.
- The owner must provide the capital for the most part. Most banks don’t like to loan or charge higher interest rates to sole proprietors as they prefer the liability protections from more complex structures.
Partnership
- Two or more owners, usually equal in ownership
- State registration, partnership agreement needed
- Minutes of meeting needs to be kept and agreement reflect changes voted on
- Income taxes are paid through partners’ individual 1099 in percentage in the partner agreement
- A partnership agreement spells out how the partnership ends.
- Profits or losses are based on the partnership agreement percentage of ownership
- While each partner’s ownership is spelled out in the partnership agreement, the liability of the company falls 100% on each partner potentially.
- Partner agreement should spell out if partners can sell or transfer any or all of their interests.
- Each partner is considered self-employed and must pay quarterly estimated taxes and self-employment taxes (Social Security and Medicare) according to their percentage of profits.
- Partners usually must provide capital for the most part. While most banks prefer partnerships to sole proprietorship, they still prefer the liability protections of the more complex structures.
Limited Partnership
All Partnership factors remain the same except:
- One partner is a general partner, all other partners are limited partners
- General partner must have a management role, limited can have limited management roles, but are not required (and often don’t)
- The general partner can bear 100% of the liability, limited partners are only liable to their share of the business.
Limited Liability Partnership
- all partners are limited partners
- similar to Limited liability companies (below), with a few less “hoops”
- Lawyers, accountants, and doctors qualify for Professional Limited Liability Partnership
Limited Liability Company
- The owner is called a member
- Can be a single member or multiple members
- Can be member-managed or manager (nonmember) managed
- You must register your LLC with your state and create an operating agreement
- Must hold at least yearly meetings and minutes must be taken at a meeting
- Members are limited in their liability up to their investment in the business.
- Can choose to be taxed like a sole proprietor (single-member LLC) or a partnership (multi-member LLC) or like an S-Corp, all of which is a pass-through on owner’s individual 1099 OR as a C-Corp separate entity
- The operating agreement dictates the ability to transfer part or all of an owner’s shares.
- Profit or loss is distributed to the member(s) according to their share.
- Each member is only liable to the amount of their investment into the LLC
- Each member is considered self-employed and must pay quarterly estimated taxes and self-employment taxes (Social Security and Medicare) on their portion of profits.
- Banks find this a more desirable structure though still preferring corporations. Investors that won’t be members usually only invest in corporate structures.
S-Corporations
- 100 or fewer shareholders (owners) that must all be US citizens
- Private corporation only
- Is actually a tax designation of a corporation. Is established by filing for a corporation with the secretary of state in your state and then electing S-Corp status when signing up for Tax ID.
- Requires bylaws, articles of incorporation, board of directors that choose overall direction of the corporation, the board chooses officers who run day-to-day operations, minutes must be recorded each meeting, annual filings with the secretary of state
- Corporations are separate legal entities; therefore, shareholders are only liable for the amount invested
- Corporate taxes are passed through to shareholder personal 1099 by their percentage of ownership in the form of a dividend. Shareholders who are also officers or employees shall be paid a reasonable salary which they will pay on their regular taxes and self-employment taxes. Salaries are an expense of the business and reduce the profits when figuring dividends. Taxes are paid at the regular rate on their1099, but only regular taxes and are exempt from self-employment taxes.
- As a separate entity, the corporation survives regardless of shareholders’ exit or death.
- Profits are paid to the shareholders as dividends, according to their percentage of all stocks owned. Losses are taken by the shareholders on their individual taxes per their percentage of total stocks owned also.
- Article of Incorporation or its voted changes will dictate if shares can be sold or transferred. It will also control what happens to shared ownership at a shareholder’s death.
- The preferred structure of banks and investors in raising capital.
C-Corporation
- Unlimited number of shareholders
- Can be private or publicly-traded
- Is actually a tax designation of a corporation. Is established by filing for a corporation with the secretary of state in your state and then electing C-Corp status when signing up for Tax ID.
- Requires bylaws, articles of incorporation, board of directors that choose overall direction of the corporation, the board chooses officers who run day-to-day operations, minutes must be recorded each meeting, annual filings with the secretary of state
- Corporations are separate legal entities; therefore, shareholders are only liable for the amount invested
- A corporation pays taxes at the corporate rate. Shareholders who are employees must be paid salary which will be deductible to the corporation and taxes will be withheld each paycheck, including Social Security and Medicare.
- Stockholders pay taxes on any dividends paid by the corporation (since dividends are not tax-deductible to the corporation, this is where you hear the term double taxation) and any capital gain on stocks sold.
- Since a separate entity, the buying, selling, or transfer of shares or death of stockholders, has no effect on the continuity of the corporation.
- Profits are paid to shareholders in form of dividends paid per share.
- Unless not allowed in a private corporate article of incorporation, stocks are free to be bought and sold and as a separate entity, no sale, transfer, or death of a stockholder affects the corporation’s continuity.
- The preferred structure of banks and investors in raising capital.
Non-Profit
- a tax-exempt entity that can not distribute its profits (i.e., pay dividends)
- limited to charity, education, religious, literary, or scientific work
- considered a benefit to society
- do not pay taxes to help them have more to work with towards their societal benefits.
B-Corporation
- a hybrid of C-Corp and nonprofit
- for-profit but are deemed a benefit (hence the name) to society
- adhere to third-party validation, public transparency, and legal accountability standards to maintain status
My Guideline for Factors to Consider “What Business Structure Should I Choose?”
Your structure should match up to the needs and complexity of the type of business you want.
- Sole Proprietor is best for a sole person working from home or leasing small office space with no employees, especially selling services only.
- The partnership is best if more than one owner, but no other employees. If you are dealing with a business that could bear liabilities or will need to secure lines of credit to operate, you may want to start with an LLC.
- If you are selling products, especially that you make yourself, have a few employees, or have a good chance of business liability, you should consider starting with an LLC or S-Corp.
- If you have a large business with many owners, need large amounts of capital, credit lines to operate, or plan to publicly trade in the near future, consider starting with C-Corp.
- While Partnerships are simpler to set up and have fewer rules to operate, if more than one owner (even if a spouse), consider if LLC would be better to start with.
Remember that whatever you start with, you are allowed to change to another more complex structure once you grow, add employees, and become more profitable; OR as your personal assets grow and need to be protected from business liabilities.