Ready to Start Your Own Business? Choosing the Right Business Structure is Crucial
Ready to Start Your Own Business?
Choosing the Right Business Structure is Crucial
So, you have come up with a brilliant idea and you think to yourself, “I should start a business…but where do I start?” If you google “how to start a business,” you’ll soon discover that there are several different types of business structures, including these six:
Determining which business entity is best for your situation is important, and failing to understand the differences between these options can lead to critical mistakes down the road. We encourage you, therefore, to take time to consider your goals and future potential needs, and learn the differences in these entities. The following information should help you do that.
Better yet, seek out a professional who can help you make sense of the legal ramifications and potential pitfalls of different business structures. We recommend spending time to find and consult with either a tax professional—a Certified Public Accountant (CPA) or Enrolled Agent (EA)—or a business attorney. These experts can ask you important questions and guide you down the path that is right for you.
In many cases, a tax professional (CPA or EA) is a great place to start. First, they will examine your past tax returns, consider where your business is today, and help you plan for where you hope/expect your business to be years from now. Based on all of those factors, they will narrow the above six choices down to one or two.
CPAs and EAs are specifically qualified to evaluate your business plan, current resources, financial forecasting, and tax situation. They can assist you in making realistic projections, and then adjusting them down the road as your business moves forward. Tax professionals also tend to have lower hourly rates than business attorneys, so they might save you a considerable amount of money.
Whichever you hire—a tax professional or a business attorney—getting their professional advice before choosing a business structure is definitely worth an initial consultation, which they will often do at no cost or obligation (as we do at Viridian).
To make the most of that professional advice, it will be helpful for you to have an idea of some of the features and tax saving opportunities each business structure offers, and which ones might be most appropriate for you, before you meet with them. Let’s review each one:
Sole Proprietorship – this is the most basic type of entity, and it is perhaps the simplest form of business organization. A new business with only one owner usually defaults to the sole proprietorship structure. That is because a sole proprietorship is not a legal entity separate and apart from its owner; you are the business and the business is you. In a sole proprietorship, the owner holds the title to business, conducts business for profit, and is directly and personally liable for all obligations of the business.
From an income tax standpoint, the business’ income and expenses flow directly through to the sole proprietor as an individual. Unfortunately, this entity provides no real shield to protect you and your assets; the government or creditors can take your personal assets (home, car, and income) to rectify debts if the business fails and is unable to meet its liabilities.
As we explore this and other start-up business options, I will assign two scores to each—one for the ease of getting started, and one for their exposure to (lack of protection from) risk/liability. Each score will be from 1-5 (with 1 being good, and 5 being bad). For ease of getting started, a sole proprietor could hardly be easier. But it exposes you personally to basically unlimited liability.
– Ease of formation: 1 (simple)
– Liability protection: 5 (worst)
Limited Liability Company (LLC) – this is an entity created under state law that is owned by one or more “members.” LLCs combine the tax advantages of a sole proprietorship or partnership, but with the liability protection of a corporation. The main tax advantage is the “pass-through” of taxable income, so that the income is taxed only once (to the members), not at the entity level and then again to the members.
A single-member LLC can choose to be taxed as a sole proprietorship, a “disregarded entity” (i.e., part of the member’s personal tax return), and/or as a corporation. A multi-member LLC must choose to be taxed as either a partnership or as a corporation.
The LLC is one of the most popular structures, and it is extremely flexible. Like a corporation, an LLC offers limited liability protection to its owners, yet it has fewer corporate requirements and formalities, and greater tax flexibility. One disadvantage is that profits may be subject to self-employment taxes.
– Ease of formation: 2 (fairly simple)
– Liability protection: 2 (very good)
General Partnership (GP) – this is an entity with two or more persons as co-owners who choose to go into business together with hopes of making a profit. Many new businesses with multiple owners’ choose the general partnership structure. A partnership is an entity separate from any of the individual owners. Like an LLC, it allows the pass-through of taxable income to the partners and isn’t taxed at the entity level. Co-owners in a general partnership personally share the risks and rewards of all phases of the business. Tax rules and regulations can make partnerships increasingly complex entities.
Partnership agreements are critical to the success of a partnership; without one, the GP is subject to a set of default rules. For instance, upon the death or resignation of any partner the partnership is automatically dissolved, requiring any remaining partners to re-form the business. This default can be avoided by the partnership agreement.
A key consideration for a GP is the fact that each general partner is jointly and severally liable for all of the partnership’s obligations. Like sole proprietorships, a partner’s personal assets can be seized to satisfy partnership debts, even if another partner was responsible for making bad decisions.
– Ease of formation: 1 (easy)
– Liability protection: 5 (worst)
Limited Partnership (LP) – this is a special type of partnership with tax characteristics (e.g., pass-through of taxable income) like those of general partnerships. Like GPs, a limited partnership must have at least one general partner, who is responsible for managing and controlling day-to-day operations, and who also retains unlimited liability. The main difference is that LPs also have at least one “limited” partner, who is not personally liable for any of the partnership’s liabilities.
Limited partners are restricted as to the amount they can participate in the business, but they have much less liability (typically limited to the money they invest in the LP) than the managing general partner, as well as all partners in a GP.
– Ease of formation: 3
– Liability protection: 1 for limited partners, 5 for managing general partner
Limited Liability Partnership (LLP) – this is a special type of partnership that exists under applicable state law. This is generally a favorable form of organization for professionals who are providers of professional services (e.g., attorneys, CPAs and physicians). In most states, LLPs are a good alternative to LLCs, especially where professional service firms are not allowed to organize as LLCs.
- Pass-through taxation status
- Flexibility to structure ownership interest
- Most states give LLPs the same liability protection as LLCs
- In some states, partners are personally liable for the debts and other obligations of the LLP.
– Ease of formation: 2 (simple)
– Liability protection: 2 (states with same protection as LLCs) to 5 (other states)
Corporations are established under state law for the purpose of conducting business. They are characterized by having fictitious name (i.e., not the name of the owners) so they can hire employees as needed to run the day-to-day business. A very important feature of corporations is that, like limited partners in LPs, they usually allow owners to limit their liability to their initial investment. For example, if $50,000 was made as a down payment to purchase a franchise, the entity would only be responsible for the $50,000 instead of the entire amount to purchase the business. The franchisees are type of owner’s that simply want to create a family business that is respected in the community and provides a steady cash flow, and owner-employees generally can receive a full array of employer-provided tax-free fringe benefits.
For tax purposes, corporations are usually one of two types: C-Corp or S-Corp (each referring to the governing subchapter of the Internal Revenue Code). Corporations – especially C-Corps – are by far are the most complicated entities, both to establish and maintain. They require things like articles of incorporation, annual meetings, meeting minutes, corporate resolutions, and the list goes on. Why are they so difficult? Primarily because they provide a great deal of liability protection.
C-Corporation (aka C-Corp)
The highest level of liability protection is in a C-Corp, and that is because it truly is a separate entity, removed from its owners. Most companies whose stock you can buy on a stock exchange are C-Corps.
A C-Corp does not benefit from pass-thru of taxable income and expenses to the individual. Income is taxed at the corporate level, and to the extent that profits are paid out to shareholders (as dividends), those dividends are taxed (again) to the recipients. This is often referred to as “double taxation.”
– Ease of formation: 5
– Liability protection: 1 (best)
Subchapter S-Corporation (aka Sub-S Corp or just S-Corp)
S-Corps, also commonly known as “Sub-S Corps,” offer a little less protection, but the same amount of difficulty in formation. Why would you choose an S-Corp “election?” Because the tax treatment can be considerably more advantageous than with a C-Corp.
S-Corps do get pass-through of profit taxability to individual owners (shareholders) at their own ordinary income-tax rate, with no double taxation, just like Sole Proprietor, LLC, and partnerships. When S-Corp profits are distributed, they are neither subject to self-employment tax nor treated as taxable dividends. Thus, while an S-Corp still gets a rating of 5 for difficulty of formation, it has better tax benefits.
– Ease of formation: 1 (but without double taxation)
– Liability protection: 2
What’s Next for You?
Congratulations! You now have a basic understanding of the main business structures! With the above details and considerations, you might have already made an educated guess as to which structure is best for your new business.
Perhaps you’re leaning towards the LLC structure, and you wouldn’t be alone. LLCs have become very popular because they are fairly simple to set up, they get you the same pass-through tax benefits as a sole proprietorship, partnership or Sub-S Corp, and they offer the liability protection of a corporation.
This would be a good time to seek some professional guidance, as I mentioned earlier, just to make sure that the structure you think will be best actually is the best for your business. For instance, the 2017 Tax Cut and Jobs Act impacts several of the above types of businesses, making C corporations more attractive than before, and helping certain pass-through entities by offering something called the Qualified Business Income (QBI) Deduction. A tax professional can determine if these and/or other tax rules favor your use of one business structure or another.
As your business grows and the bottom line turns from red ink to black, proper planning and professional guidance can continue to help you limit your tax liability. Don’t forget that having to pay taxes is a good thing; it means you are making money. Strong business owners plan ahead, and they utilize professional guidance to help manage their tax liability.
Viridian is an SEC Registered Investment Advisor (RIA) with clients across the United States. Viridian offers financial planning, investment management, and tax services (through its sister company, Viridian Tax and Accounting).