One of the key decisions that you will need to make as a business owner is the structure of your business. This might be dictated by the size of the business, the number of employees, the nature of the business, or what product or service you will provide.
The right business structure can provide tax benefits for the owners, allow for future growth and provide a shield from personal liability. This decision should be made with the help of an outside adviser such as an attorney or accountant.
Types of Business Structure
There are many ways to structure your business. Here is a discussion of some of the most popular types of business structures.
Sole proprietorship is the easiest type of entity to set up in that there is virtually nothing to do. For example, in my home state of Illinois there are is no paperwork to be filed, this will vary from state to state so be sure to check the rules in your state.
The owner of a sole proprietorship owns this business by him or herself. There is no separate legal entity as with the other types of business structures portrayed here.
- The owner has full liability there is no corporate entity to serve as a buffer.
- The owner files a Schedule C as part of their individual tax return. A sole proprietorship is considered to be a pass-through entity and can benefit from the 20% pass-through deduction. This can also be the case for an LLC and an S-Corp as well as for the partners in a partnership.
- A sole proprietorship is the easiest business entity to start.
A partnership is initiated by a legal agreement between two or more business partners. There can be a combination of partners who actively work in the business and some who don't.
A partnership is not a separate corporate entity like an LLC, S-Corp or a C-Corp. The partners do not have an entity to serve as a buffer between liabilities incurred by the partnership and their personal assets. In this respect it is much like a sole proprietorship.
Profits and losses from the partnership are divided among the partners and flow through to their personal income tax returns.
There are different types of partnerships and it is important that a partnership agreement is established to define things like ownership percentages, the various partner's roles and what happens in the event that the partnership is dissolved. Each state has their own rules regarding the registration of a partnership, it's important to check with your state.
Limited Liability Corporation (LLC)
A limited liability corporation (LLC) is widely considered to be a flexible business structure and a relatively easy one to create. It is a bit of a hybrid between a sole proprietorship and a corporation.
An LLC offers the limited personal liability protection of a corporation with the pass-through income features of a sole proprietorship or a partnership. You can elect to have your LLC taxed as an S-Corp if you desire as well. Members of the LLC are also insulated from the creditors of the LLC.
However, if you are looking to raise outside financing for your business, an LLC is not the way to go as this is not allowed for an LLC.
A few other features of an LLC include:
- The LLC can have an unlimited number of members.
- LLC members do not have to be U.S. citizens.
- LLCs can be owned by corporations or even other LLCs. They can have subsidiaries as well.
An S-Corp is a corporation that elects to pass through its income, losses, deductions and credits to the corporation's shareholders. The shareholders report this pass-through income on their personal tax returns.
An S-Corp has several restrictions:
- There can be no more than 100 shareholders.
- Only one class of stock is allowed.
- It must be a domestic U.S. corporation.
- There are restrictions on the types of shareholders allowed, for example shareholders may not be partnerships, non-resident aliens or other corporations.
An S-Corp offers protection from business creditors and from liability issues that arise during the course of conducting business. Owners who work in the business will typically be paid a salary that is taxable to them on a personal level. They may also take draws from the business which are generally not taxable on a personal level.
A C-Corp is a separate taxable entity; unlike an S-Corp or an LLC, a C-Corp files its own tax return. They pay taxes at a separate corporate tax rate. A C-Corp can be subject to double taxation if dividends are paid to shareholders, as the receiving shareholders may be taxed on the dividend payments that are made with income that has already been taxed at the corporation level as well.
As with an LLC and an S-Corp, there is a corporate veil protecting the owner's personal assets from corporate creditors and liabilities incurred by the corporation. Owners who are employees of the corporation will generally receive a salary which is taxable to them personally.
Unlike with an S-Corp, there are no restrictions on ownership or on having multiple share classes. Many major companies who are household names are C-Corps and have their shares traded on the major stock exchanges.
A nonprofit organization is one that has been granted non-profit status by the IRS. These organizations often accept donations which can be tax-deductible to the donors. Their workers may be paid staff who will receive a salary that is taxable to them on their personal returns, as well as unpaid volunteers.
A nonprofit typically:
- Serves a purpose or benefits a specific need/cause.
- There is no private ownership of the assets of the organization.
- Control of the organization typically rests with a governing body of some sort, not private owners.
- A nonprofit must file various reports that show the flow of money in and out of the organization, and that demonstrate that they are true to their charter.
A 501(c)3 is a typical classification for organizations, but there are other classifications such as foundations that fund other nonprofits and charities.
While there are no taxes on a nonprofit, there are very strict disclosure and filing requirements that must be completed during the year in order for the organization to maintain a nonprofit status.
What Business Structure Is Best for You?
The right structure for your business will depend on a number of factors tied to the type of business, whether you have employees and how many, your tax situation, the need to have a corporate veil to limit your personal liability and a number of other potential factors.
Regardless of the structure you choose, some things you should consider include:
- Keep business transactions separate from your personal transactions. This includes opening a separate business bank account and perhaps obtaining a separate business credit card.
- Ensure that you have an accurate business accounting system.
- Even if your entity has some sort of a corporate veil, you might need personal liability insurance to ensure that your personal assets are not at risk.
- As needed, hire outside advisers such as an accountant and an attorney.
This is an important business decision both initially and over the life of your business. Take the time to review your situation and adjust accordingly if needed.
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