Among the first key decisions you make as a business owner is choosing a legal business structure. A business structure is a critical determinant in many components of your business including taxes, raising capital, daily operations, and the amount of paperwork to file. As a result, you should choose a business structure that benefits you and protects you.
Here are the most common types of legal structures:
The business is owned and operated by one individual, known as the sole proprietor. A sole proprietorship does not create a separate legal entity from the sole proprietor. This implies that the business owner is fully liable for debts, and other liabilities in the business.
Tax-wise, the income and expenses of a sole proprietorship are not separate either. They are included in the tax return of the owner. Additionally, as the business owner, you are responsible for record-keeping and paying IRS the self-employment taxes.
This business structure is simple and doesn’t require formalities or annual reports. Other advantages include: the sole proprietor has total control of the business and it is simple to set up. Therefore, less costs are involved.
However, there is an unlimited personal liability and it is hard to raise capital since there is only one person involved.
This is a business structure owned and operated by more than one person. It is similar to a sole proprietorship in that, it does not exist as a separate legal entity from the owners.
One of the benefits of this structure is the tax advantage. It is interesting that tax is not paid on income but on any profit or loss passed down to the partners/owners. Each partner includes his or her profit or loss on his/her tax return.
In a partnership, there is access to a wider range of expertise when you have a good partner, more capital and it’s cost-saving since you have someone to share the financial burden with.
On the down side, there is no control for one individual, one partner can be personally liable for the debt of other partners, and sometimes partners can collide causing disagreements or disputes.
Also known as C-corp, this business structure is recognized by the state as an entity that is separate from its owners (also known as shareholders).
A corporation can be owned by people and/or other entities. Ownership is transferred through the buying and selling of shares. As you can see, this structure is a bit different from the other two. It is more complex and requires more work than the other two above.
To identify as a corporation, the business owners must follow their state’s legal requirements. Hence, more paperwork is involved.
It protects the owners from personal liability in case of debt or legal issues
More money: corporations can raise money through the selling of stocks
From a tax perspective, a corporation is subject to double taxation. What that means is, owners pay corporate taxes and then the dividends paid to shareholders are also taxed at their personal income tax rates.
The famous LLC offers the best of both worlds. This structure has characteristics of both corporations and partnerships.
Provides asset protection in case of liabilities
No double taxation
Income and losses are transferred to owners subject to their personal income tax rates
The owners of an LLC are known as members and not shareholders. An LLC is quite flexible; it can either have one member and be taxed as a sole proprietorship, have more than one member and be taxed as a partnership, or can choose to be taxed as a Corporation, or S-corp.
On the downside, it is expensive to set up because you have to file articles of organization with the secretary of state where you’re planning to start a business. Also, an LLC is subject to self-employment tax.
An S-corp has some similar features as a corporation including personal liability protection, ownership, and management advantage. However, there is a key feature that distinguishes it from a C-corp: the tax advantage it provides.
S-corps are attractive to small business owners. They are perfect if you are looking for a structure with the advantages of a corporation paired together with attractive tax benefits.
This is why:
Like corporations and LLCs, S-corps offer asset protection in case of liabilities, court cases and related risks. This means that your personal assets are not at risk at all.
An S-corp is a pass-through entity for federal and most states income tax purposes. The profits are passed down to the owners. For this reason, there is no double taxation because when the income is passed down to owners, it’s included in their personal tax returns. S-corps do not pay corporate taxes.
There are both salary and dividend payments.
Owners of an S-corp are considered employees of the business. They can choose to receive both salaries and dividends. As a result, this will reduce the tax bill of the business because dividends are not subject to self-employment tax.
S-corps can also lower their tax bill by reducing the cost of salaries paid when calculating the profits passed down to shareholder under one condition… both payments should be “reasonable”
Disadvantages of this structure
Many entrepreneurs prefer to set up a business structure that protects their personal assets. It is extremely important to consider this feature when setting up a business.
Once you understand each structure, the benefits that come from each, pros and cons, you are in a better position to decide which one will be perfect for you.