Starting your own business comes with filings and certain responsibilities that enable you to operate legally and pay taxes on the income you receive. Deciding which corporate structure fits your business best is a key business decision that will affect how you report your taxes to the IRS and state, gain access to capital, and the future you foresee for your business. Each type of business entity, or corporate structure, has advantages and disadvantages that can help you attain the growth you desire for the business, reach income goals while reducing effective tax rates, and protect your personal assets. The following is a look at the four most popular types of business entities and what’s involved in their creation.
Sole Proprietorship
A sole proprietorship is the simplest of all business entities. It requires no filing of paperwork for its formation, you don’t need to get an Employer Identification Number (EIN) from the IRS unless you want to protect your Social Security Number, and you can start and cease operating whenever you wish. Operating as a sole proprietorship is also known as being a contractor or subcontractor. It can also be referred to as a 1099 position or contractor due to the fact your client is required to issue you a form 1099-Misc if they pay you more than $600 in one year.
A sole proprietorship does not protect your personal assets from business liabilities, and you can be held personally responsible for any business debts or lawsuits.
The person or entity you’re working for pays you an agreed-upon amount for the work you provide, and you handle and pay all applicable taxes in accordance with the amount you’ve earned. Working as a sole proprietor allows you to set your own hours of employment, frees you from the control of an employer, and enables you to name your own price for a job or contract. You’re also allowed to deduct certain costs of operations that reduce the amount of tax you pay.
Disadvantages of a sole proprietorship
Working as a sole proprietor does have its drawbacks, even though it has more freedom in terms of its operation. The IRS requires you to pay estimated quarterly taxes if you’ll owe at least $1,000 in federal income taxes for the year. You’re also responsible for paying both portions of the employment tax for a total of 15.3 %, something that you split 50/50 with an employer as a W-2 employee.
Getting access to funding can be difficult as a sole proprietor due to the fact you’re not required to open a business checking account. The income from the sole proprietorship can be deposited into a personal checking account. However, a lender may not feel comfortable giving you access to funding because you don’t have a clear separation of your income and outflows. This is the reason why many sole proprietors eventually form a partnership, LLC or a traditional corporation for more favorable taxation and access to capital.
Limited Liability Company (LLC)
Many people decide to form an LLC because of its simplicity, relatively low cost of formation, and the ability to pass income through to the members for favorable tax treatment. The LLC pays no tax on the income because it’s passed through to the members instead. An LLC also protects your personal assets from legal action, something a sole proprietorship can’t. Another advantage is the option to form an LLC for the purposes of a short-term project with partners, then dissolve the LLC once the project is finished.
All U.S. states have different rules for forming an LLC, but all states require your LLC to appoint a registered agent to act as the point of contact for LLCs with their state. You’ll want to get familiar with how your state handles the formation and ongoing maintenance of an LLC before you select a business name and fill out and file the articles of organization, then open a bank account in the name of the business.
Benefits of forming an LLC include:
- Flexible management structure
- Enforceable operating agreement
- Easy to start and maintain
- Low filing fees
- Easier access to sources of capital
Disadvantages of an LLC
There are some disadvantages to forming an LLC, including the fact that the IRS classifies a single-member LLC as a disregarded entity. That is, the income from a single-member LLC is treated the same as if they were a sole proprietor. The income from the LLC has to be declared on Schedule C of Form 1040 the same as a sole proprietorship. However, if you decide to treat the LLC as a corporation, you won’t be considered a sole proprietor and you won’t be taxed like one.
Another disadvantage of the LLC is the fact that the word “limited” refers to the fact that it’s easier for a judge in a lawsuit to take an action known as “piercing the corporate veil” and expose your personal assets to the plaintiff.
Some states require the dissolution of an LLC in the event a member passes away, leaves the LLC, or goes bankrupt.
S-Corporation or C-Corporation
The IRS allows you to form one of two types of corporations known as an S-corporation (S-corp) or a C-corporation (C-corp). The S-corporation is similar to the LLC in that it’s a pass-through entity for the purpose of taxation, while the C-corp has its corporate profits taxed instead of passing the income to the owners or members. You can elect to incorporate under either type in accordance with how you want to structure your tax liabilities and income flow. Both of these corporate structures offer the most personal liability protection, and the corporate veil is not as easily pierced as it is in an LLC.
S-Corp
The S-corporation avoids double taxation on corporate income in that it allows the profit to be passed directly to the owner’s personal income and isn’t taxed at the corporate level. Some losses can also be attributed to the owner(s) for the purpose of reducing personal tax liabilities. Personal tax rates are lower than corporate tax rates, which makes the S-corp a good option for those who are looking to reduce their tax liability.
Most states tax S-corps in the same way as the IRS does, but not all. You can learn more about how your state taxes S-corps on the state website or you can consult with a lawyer or tax professional.
C-Corp
The C-corp is the most common type of corporation, but its major drawback is the fact it has double taxation as a feature. The corporate profits are taxed along with the dividends paid out to the shareholders. On the surface, the double taxation may sound unappealing, but the C-corp offers the strongest protection for personal liability due to the fact that a C-corp is a completely separate entity from its owners. Someone can sue a C-corp, but the lawsuit can only be brought against the corporate entity.
Forming a C-corp enables the corporation to issue shares of ownership to the principals and others that are brought on board later. In the event one or more shareholders decide to leave the C-corp or sell their shares, the corporation can continue forward without the need for dissolution and reformation. Shares can be sold at will in order to raise capital, and they also give the corporation the option to sell its shares on the open market or be sold sometime in the future.
The C-corp structure works best for the formation of a business that’s outgrown an LLC, higher-risk operations, and when there are plans to sell the business when it reaches a certain level of growth.
Overall Advantages of Filing for S- or C-Corporation
Both types of corporate structures offer stronger personal liability protection than an LLC does. The S-corp works for owners who want to pay less in tax on their profits, while the C-corp provides a pathway for a future sale or expansion of stock offerings.
Disadvantages of S- and C-Corporations
Incorporating under either type of corporate structure requires a lot more paperwork than the creation of an LLC. Corporations are filed at the federal level with the IRS and at the state level with the relevant office. The fees for filing corporation articles of incorporation tend to be higher than they do for an LLC, and states require more paperwork to keep a corporation in compliance with state laws.
Partnership
Partnerships come in three common types. They include:
- General partnership (GP)
- Limited partnership (LP)
- Limited liability partnership (LLP)
Some states have what’s known as a limited liability limited partnership (LLLP), but not all.
A general partnership is similar to that of the sole proprietorship in that there is no need to file paperwork with the state, nor are there ongoing fees. A limited partnership assigns unlimited liability to at least one partner, while the rest have limited liability that protects their personal assets. An LLP is generally restricted to use by professional service businesses including doctors, dentists, architects, lawyers, accountants, and any other type of service designated as professional by state law.
Benefits of forming a partnership include:
- Increased cash flow
- More responsible people involved
- Potential for more business opportunities
- Favorable tax structure
Disadvantages of partnership
The disadvantages of partnerships come in the form of the loss of autonomy and some control, especially if you’re used to working by yourself. You’ll also have more paperwork than before, along with the need to keep closer track of the operation. It’s also advisable to draw up an operating plan to hold accountable all who are involved.
The different types of business entities are designed to offer flexibility and structure in terms of their formation, organization, and taxation. What works for one person may not work for another, and some may prefer to have a formal corporate structure to enforce operational rules. Make it a point to select the one that works best for you, and if you’re not certain, consult with a lawyer or tax professional for guidance.
