A business structure is the legal and financial skeleton for your new business idea.
Which one you choose will determine some important things about your business – how you get paid, how you do your bookkeeping, and how you pay your taxes.
Different Types Of Legal Business Structures
The main types of legal business structures in the US are sole proprietorship, LLC, partnership, S corporation and C corporation. Let’s look at how each one works.
Sole Proprietor Business Structure
Sole proprietor is the easiest way to start a business. There is no legal business structure to a sole proprietorship, no rules for how you must keep your books, and no separate business tax return. All the profit from the business is reported on your individual tax return.
This is both good and bad. It’s simple, it’s quick, and you don’t need to invest any time or money into creating a legal business structure or filing an annual report.
On the other hand, you have no legal or financial protection between yourself and your business. You are personally liable for any loans you take out for your business, and would be personally liable if anyone were to sue your business.
You are also both employer and employee, and are required to pay self-employment tax, in addition to income tax, on your business profits.
Single-Member LLC
If you were looking to change legal business structures, you might consider a single-member LLC. This is the next step above a sole proprietor. The LLC, or limited liability corporation, sets up a corporate shield between you and your business.
The advantage of an LLC is that it creates a legal separation between your personal assets and your business assets. Your business can have its own line of credit regardless of your personal credit.
The downside of an LLC for a brand-new venture is the upfront cost of establishing it. Many small business owners and freelancers never establish an LLC, as they don’t ever make enough money to justify the expense.
However, if you are starting a venture that you expect to quickly scale, an LLC business structure can give you more legal and financial flexibility down the road. If you expect to add additional partners later, or make enough money that a corporate tax structure would yield a lower tax rate, the LLC is a good place to start.
Tax wise, an LLC has some choices. The default LLC taxation is the same as the sole proprietor: all the profits flow to the owner’s personal tax return and the LLC itself pays no tax. However, LLC’s have the option to choose to be taxed as S or C corporations if that makes more financial sense later on.
Partnerships
A partnership is a legal business structure with two or more co-owners. The earnings from the business are calculated and reported to the IRS on an informational basis. A separate report is issued to each partner of the business showing them their portion of the profits. This is reported on each of the partners’ individual tax returns as income.
There are two main types of partnerships. A general partnership is one where both (or all) partners are active in the business. A limited partnership is one where one or more of the partners is not actually active in the business, but initially invested in it and is entitled to a share of the profits.
The drawback of a partnership is that you must find a business partner whom you can absolutely trust. If there are any problems down the road, it can affect both partners and the entire business. Start off on the right foot by checking credit scores for all partners and ensuring personality compatibility.
S Corporation
An S corporation is not truly a legal business structure, but merely a tax entity. LLC’s and C corporations that meet certain size and activity requirements can choose to be taxed as S corporations instead of as sole proprietors or C corporations.
The main advantage of an S corporation is that it pays the self-employment tax, but does not pay any actual federal income taxes. The only part that gets taxed is what is paid out to the owner-employee, and any other employees, in salaries. Depending on how much profit the business makes, this can be a major tax savings for the owner.
The drawbacks of an S corporation are that it is limited in size, it can be expensive to maintain (especially here in California), and there are certain business sectors that do not see any tax savings from an S-corp due to other limitations in the legal structure.
C Corporation
C corporations are the business entity most separate from their owners. Generally, businesses have to be very large or very profitable to see the most benefits from a C corporation structure.
C corporations get taxed twice. They pay corporate income tax on the business’ profits, and then the shareholders/owners get taxed individually on their portion of the business’ earnings. They are also required to file an annual report with their state of incorporation, and publish this report, including financial statements, for all owners and shareholders.
Because of this reporting requirement, corporations are required to follow generally accepted accounting principles in their bookkeeping. An Excel spreadsheet is not enough.
If you need a business structure that is absolutely separate from your personal life, and that has no limits on size or growth, the C corporation is most likely the right choice.
Why Does It Matter Which One I Choose?
Each legal business structure has its advantages and disadvantages. Some, like S and C corporations, are more expensive to establish and maintain, but provide long-term benefits for the business. Others, like sole proprietorships, are easy to start but do not provide the same opportunities for growth or protection of personal assets.
Competent accounting services or a financial advisor can help you decide which is the right one for your business.
How To Form Each Legal Business Structure
Sole Proprietorship
There is no official formation process for a sole proprietorship. If you like, you can apply for an EIN number so your business can have its own bank account. This isn’t necessary though – many small and micro-businesses do just fine with all their information under the owner’s personal social security number.
LLC
To register an LLC, go to your state’s secretary of state website. You will need your business’ information. Some states only require a business name and address. Others need more detailed information. Filing fees vary by state. Once you have your LLC, you can apply for an EIN number for your LLC.
Partnership
You will need to create a partnership agreement for all partners to sign. Then, decide if your partnership will be general or limited. Finally, register with your secretary of state.
S Corporation
Since an S corporation is merely a tax status, you register an S corp the same as you would an LLC. Then, if your business fits the size and activity requirements for an S corporation, you file Form 2553 – Election by a Small Business Corporation to be taxed as an S corporation. This only has to be filed once, and does not need to be filed again. However, if you outgrow the S corporation status, you must choose to be taxed either as an LLC or a C corporation.
C Corporation
Register a C corporation with your state’s secretary of state. There is an initial registration fee and an annual filing fee. If you do business in more than one state, you must pay any franchise tax due to those other states as well.
FAQ’s
As of 2023, the LLC was the most popular business structure in the US.
This is because of its ease of setup, flexibility in size, and different options for business growth and taxation.
It truly depends on the size of your business. If you have a very small business, a more complex business structure like a C corporation will only mean higher yearly fees and possibly a higher tax rate as well. On the other hand, a very large business may actually profit from a C corporation over LLC status as the corporate tax rate may actually be less than their individual tax rate at that point.
There are many situations where small businesses can benefit from electing S corporation status to reduce their tax burden, but this is not necessarily the case. Consult with knowledgeable online accounting services before making this decision.
The most effective business structure is the one that lets you run your business with the minimum of paperwork and risk. For the majority of small businesses, this is probably an LLC. This gives you legal protection of your business, but does not require the additional paperwork of a full-fledged C corporation.
Contact Us to see how we can help your business thrive.
