CHOOSING THE RIGHT BUSINESS STRUCTURE
When you’re ready to start your own business, set yourself up for success.
So, you’ve come up with a brilliant idea and you think to yourself, “I should start a business … but where do I start?” With just a little research, you’ll soon discover that there are several different types of business structures, including the following:
- Sole proprietorship
- Limited Liability Company (LLC)
- General Partnership (GP)
- Limited Partnership (LP)
- Limited Liability Partnership (LLP)
- C-Corporation (C-Corp)
- Subchapter S-Corporation (Sub-S Corp or just S-Corp)
Determining which business entity is best for your situation is important. Failing to understand the differences between these options – and what they could mean for you – can lead to critical mistakes down the road. Take the time to consider your goals and how your needs may change in the future.
With that in mind, review the pros and cons of each business structure to determine which will best fit your needs. This is a big step, so you may want to seek out a professional who can help you make sense of the legal ramifications, tax implications and potential pitfalls of different business structures. The expert counsel of a tax professional – a Certified Public Accountant (CPA) or Enrolled Agent (EA) – or a business attorney can help guide you down the path that is right for you.
SEEKING OUT A TAX PROFESSIONAL HAS ITS ADVANTAGES
In many cases, a tax professional 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 and expect your business to be years from now. Then they’ll help you narrow down your choice of business structure to one or two. CPAs and EAs are specifically qualified to evaluate your business plan, current resources, financial forecasting and tax situation, so they can assist you in making realistic projections and adjusting them down the road as your business grows.
Tax professionals also tend to have lower hourly rates than business attorneys, so they might save you a considerable amount of money. Whoever you hire – a tax professional or a business attorney – getting professional advice before choosing a business structure is worth an initial consultation, which they will typically do at no cost or obligation.
CONSIDERING THE PROS AND CONS OF EACH TYPE OF BUSINESS ENTITY
To make the most of any professional advice, it will be helpful for you to first have an idea of some of the features and tax saving opportunities each business structure offers, and which one might be most appropriate for you.
Let’s explore each one, with a score for each in terms of ease of getting started (scored 1-5, with 1 being easiest and 5 being hardest) and exposure to risk/liability (also scored 1-5, with 1 being least risky and 5 being most risky).
This is the most basic type of entity and perhaps the simplest form of business organization. A new business with only one owner usually defaults to the sole proprietorship structure. That’s 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 the 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.
- Ease of formation: 1
- Liability protection: 5
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 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) rather than 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” (that is, part of the member’s personal tax return) and/or a corporation. A multimember LLC must choose to be taxed as either a partnership or a corporation.
The LLC is one of the most popular structures and 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
- Liability protection: 2
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, however, 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 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
- Liability protection: 5
LIMITED PARTNERSHIP (LP)
This is a special type of partnership with tax characteristics (such as pass-through of taxable income) similar to 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 (for example, 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.
Some advantages include pass-through taxation status and the flexibility to structure your ownership interest. In addition, most states give LLPs the same liability protection as LLCs. One disadvantage is, in some states, partners are personally liable for the debts and other obligations of the LLP.
- Ease of formation: 2
- Liability protection: 2 in states with same protection as LLCs; 5 in other states
SHOULD YOUR BUSINESS BE REGISTERED AS A CORPORATION?
Corporations are established under state law for the purpose of conducting business. They are characterized by having a fictitious name (that is, 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. Franchisees, or owner-employees, can generally receive an 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 the most complicated entities, both to establish and maintain.
They require things like articles of incorporation, annual meetings, meeting minutes, corporate resolutions and more. The complexity is 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-through 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
SUBCHAPTER S-CORPORATION (AKA SUB-S CORP OR S-CORP)
S-Corps, also commonly known as “Sub-S Corps,” offer a little less protection but the same amount of difficulty in formation. You might choose an S-Corp 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 proprietorships, LLCs 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 is still among the most difficult to form, it has better tax benefits.
- Ease of formation: 5
- Liability protection: 2
WHICH BUSINESS STRUCTURE IS RIGHT FOR YOU?
Now that you have a basic understanding of the main business structures and you’ve considered the pros and cons of each, you may have already made an educated guess as to which structure is best for your new business. Perhaps you’re leaning toward the LLC structure, and you wouldn’t be alone. LLCs have become very popular because they’re fairly simple to set up; they provide the same pass-through tax benefits as a sole proprietorship, partnership or Sub-S Corp; and they offer the liability protection of a corporation. Still, this would be a good time to seek some professional guidance, just to be sure the structure you’re leaning toward is the best option for you.
The tax code is constantly evolving, making some business structures more attractive than others. A tax professional can advise you on things like the Qualified Business Income (QBI) deduction and other considerations to help you determine whether certain tax rules favor your use of one business structure or another.
As your business grows, 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’re making money! Planning ahead and seeking out professional guidance will help set you up for success.
This material was prepared for informational and/or educational purposes only. Although the information has been gathered from sources believed to be reliable, we do not guarantee its accuracy or completeness.
Neither Edelman Financial Engines, a division of Financial Engines Advisors L.L.C., nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.