Choosing the perfect business structure for your new business can seem a little daunting. The incorporation process is riddled with cumbersome legal jargon, and it’s enough to confuse even the sharpest of entrepreneurs.
Like it or not, it’s crucial you do your homework. Although some business structures do share similarities, each one comes hand-in-hand with its own unique set of advantages — and the company type you choose will inevitably pose major legal implications for your business and the way in which it’s taxed.
To help point you in the right direction, here are five of the most common business structures, what sets them apart and how they’re taxed:
Which Business Structure Is Right For You?
Sole Proprietorships
A sole proprietorship an extremely basic business structure in which you’re fully responsible for a company’s assets and liabilities. You don’t need to take any action or sign any paperwork in order to form a sole proprietorship — so long as you’re the company’s sole owner, all of your business activities will automatically come under this status. Freelance writers and consultants tend to favour the sole proprietorship model.
The single greatest advantage of forming a sole proprietorship is that it is not a terribly costly endeavor. You won’t have a whole lot of legal costs, and you enjoy full control over your business and all of the decisions that it must make. That said, as a sole proprietor you will maintain unlimited personal liability for your business. Because there is no legal distinction between you and your business, you could end up losing personal assets if the business runs into trouble.
As a sole proprietor, all of your business income will be treated exactly like personal income — which makes filing taxes for business purposes extremely simple. Business income, losses and expenses are all reported on your personal return.
Partnerships
Loads of professions rely on partnership structures in order to do business. In the Unites States, there are three main types of partnership arrangements that new business can choose from: general partnerships, limited partnerships and joint ventures.
General partnerships ensure that profits, liability and management duties are equally divided among business partners. Limited partnerships are a bit more complex, and allow partners to have both limited liability and limited input on management decisions. Finally, joint ventures are effectively treated as general partnerships that come with an expiry date. Partners involved in a joint venture can continue working together after the conclusion of a joint venture, but they’ve got to subsequently file as such.
Key partnership advantages include the protection of shared financial commitments, a quick and inexpensive incorporation process and a built-in incentive for ambitious employees. On the other hand, the primary disadvantage of forming a partnership is that they do not come with limited financial liability. Similar to sole proprietorships, partners retain full liability for a company’s finances and debts.
Partnerships must register with the IRS, and will be expected to file an annual information return each year. Partnerships are also typically liable to pay employment taxes and excise taxes. Meanwhile, partners will be responsible for paying income tax, self-employment tax and estimated tax.
Limited Liability Companies
A limited liability company (LLC) is a popular business structure designed to provide the legal flexibility and tax efficiencies of a partnership with the limited liability of a large corporation. This structure is suitable for businesses operating in a wide array of industries.
The key advantage of forming an LLC is that it protects company owners from personal liability for the business activities or debts of that company. LLC owners also enjoy minimal record-keeping responsibilities, and this particular business structure makes it relatively simple to share and distribute business profits.
The only tangible disadvantage of the LLC structure is the way in which it’s taxed. In the eyes of the law, an LLC isn’t its own tax entity. That means company members are technically considered self-employed, and will be expected to pay their own self-employment taxes in order to cover things like Social Security and Medicare. It also means that LLCs must file taxes using either a corporation, partnership or sole proprietorship tax return.
How your LLC must ultimately file will depend largely upon how many members your company has. For more information on how your LLC is taxed and which forms you will need to file, it’s worth taking a look at the IRS guide to Limited Liability Companies.
Corporations
A corporation is an independent legal entity owned by shareholders, and is typically recommended only for larger businesses with multiple employees. As a separate legal entity, the shareholders and members of a corporation enjoy limited liability for company debts.
Setting up a corporation is a bit more difficult than an LLC, as corporations are subject to more complex tax requirements and legal responsibilities. That said, corporations do hold a key advantage over other business types because they are able to generate crucial business capital through the sale of company stock.
Corporations must register with the IRS — and unlike partnerships or sole proprietorships, are responsible for paying federal, state and local taxes. As a separate, tax-paying entity, corporation owners are only required to pay taxes on corporate profits that have been paid to them.
That will typically include a salary, bonuses and any dividends that may have been received. Shareholders who are also employees will be expected to pay income tax on their wages; however, some employee benefits are considered deductible or partially-deductible businesses expenses.
S Corporations
An S corporation is different from a normal corporation in that its owners are only taxed on a personal level. The owners of S corporations also enjoy limited personal financial liability, and the profits and losses of that corporation can pass through their personal tax returns. As a result, an S corporation isn’t technically taxed — only the corporation’s shareholders are paying taxes.
S corporations also enjoy a substantial amount of tax savings because only the wages of employee shareholders are subject to employment tax. A lot of employee expenses can also be written off as business expenses.
To be considered an S corporation in the eyes of the law, you must register your business as a corporation in the state where it’s headquartered. It’s also worth pointing out that not all states tax S corporations equally. For more information on S corporations and how they’re taxed, you should visit the IRS website.
At the end of the day, the type of business structure you choose for your new company will depend entirely on what it is you’re after. Sit down, and have a long, hard think about how you want your business to operate and where you see that business headed in the long-term. Above all else, if you’re in doubt, always get in touch with a professional.
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This article, "What Kind Of Business Structure Should I Use When Starting a Business?" was first published on Small Business Trends
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