Almost every new business owner asks this question: What’s the best legal structure for my business?
Unfortunately, there’s no single answer, says Gene Fairbrother, the lead micro-business consultant for NASE’s Business 101 program.
“For the majority of individuals starting a business, this is an area where you will need to get professional guidance,” Fairbrother says.
That guidance should come from an attorney and a tax professional. But, you should go into those consultations armed with knowledge.
Choices to consider
You have four choices for your legal structure:
- Sole proprietorship
- Limited liability company
“From a tax standpoint, the entity form you choose is not going to make a material difference in the amount you pay,” says NASE National Tax Advisor Keith Hall. “Choosing the correct structure should not be a tax decision but is more about liability issues, employee issues, how you see your company in the future and other issues. It’s all about planning.”
Each type of business structure provides advantages and disadvantages. The only way to know which structure will work best for your new business is to review financial, personal and tax liabilities as they apply to you.
This is a business owned and operated by one person. The simplicity of the sole proprietorship makes it an attractive option for new businesses.
The sole proprietor may or may not have employees. Creating a sole proprietorship requires minimal paperwork. The owner of a sole proprietorship reports business income and expenses on Schedule C, Profit or Loss from Business, which is filed with your personal tax return.
But there is a rather big drawback: personal liability. The owner of a sole proprietorship is personally liable for all business debts and obligations, including litigation.
A partnership is a legal entity with more than one owner. It offers many of the same benefits and drawbacks as a sole proprietorship.
Owners can be either:
- General partners, with each liable for all debts and actions of the company
- Limited partners, where liability is limited to the extent of the individual’s investment in the company
Written agreements are a must-have for partnerships. A partnership agreement will spell out how control is divided among the individual owners. A buy-sell agreement is necessary for business continuity of the partnership in case one of the partners dies, becomes disabled or wants to leave.
Profits and losses from the business pass through to the partners, who report that information on their personal tax returns.
Business owners who choose to incorporate cite two main reasons:
- Personal liability for losses is limited
- Certain tax advantages
But there is no guarantee that either of those benefits will apply to you.
Whether you can take advantage of the benefits offered through incorporation depends on your type of business and your particular facts and circumstances. Again, consult a tax professional and an attorney.
If you decide that incorporation is right for your business, you must also decide which type of corporation will work best for you:
- C corporation—May have an unlimited number of shareholders and may issue various classes of stock (e.g., common, preferred).
- S corporation—Is limited to 100 shareholders and may issue only one class of stock.
Shareholders of S corporations report the pass-through of income and losses on their personal tax returns. This avoids the potential double taxation of C corporations, where income is taxed once at the corporate level and again at the individual level when it is passed through to shareholders in the form of dividend income.
There are other important differences, too. A tax professional and attorney can help you decide which structure will work best for you.
When forming a corporation, you must follow strict legal formalities, such as:
- Preparing and filing articles of incorporation with your state’s secretary of state
- Payment of filing fees to the state
- Drafting formal bylaws governing the operations of the corporation
All shareholders of the corporation (even if that’s just you) must also follow corporate rules and observe corporate formalities, such as holding annual meetings of shareholders.
Limited Liability Company
An LLC is a hybrid structure that falls between a sole proprietorship or partnership and a corporation.
LLCs can have one owner or an unlimited number of owners. The owners are called members. The LLC structure protects members from personal liability for the company’s obligations and debts.
Like a partnership or sole proprietorship, the profits and losses of an LLC will pass through to the LLC members who report this information on their personal tax returns, if the LLC chooses to be taxed as such. An LLC can also choose to be treated as a C or S corporation, but it will lose the pass-through taxation benefits afforded partnerships and sole proprietorships, and the number of members is limited.
Sound confusing? It can be. That’s why getting help from professionals is so critical.
The NASE can help
These NASE resources will help you learn more about choosing the right business structure for your new business:
To print, click here to download the full Startup Kit.
- Business 101 Experts
Gene Fairbrother, the lead micro-business consultant for NASE’s Business 101 program answers questions about starting a business, strategic development and more. Ask your specific question online and get a confidential answer.
- TaxTalk Experts
NASE National Tax Advisor Keith Hall, a certified public accountant, answers tax questions related to startup expenses, tax responsibilities and more. Ask your specific tax question online and receive a confidential answer.
- Tax Resource Center
Learn about your tax responsibilities. Find links to helpful information. Use the online calculators. It’s all available at the Tax Resource Center.