Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.
How you choose to structure your business can have important legal and financial ramifications. Your business structure directly affects your tax status, which forms you’ll have to file with the government, who’s liable for your company’s debts, and more. It’s essential to fully research the available business entities in order to determine which is best for your particular set of circumstances.
My goal here is to provide a general overview of the different business structures and some of each one’s pros and cons. This post should not be construed as legal or financial advice of any sort. To learn more about how a particular business structure may or may not suit your needs, speak with your lawyer or accountant, as appropriate.
The most common business entity, the sole proprietorship, is a business run by a single individual, the owner. The owner has sole discretion over business operations and profits. With this discretion comes a heavy responsibility: the sole proprietor is also liable for all financial obligations. Any business debts accrued are the sole proprietor’s personal responsibility.
Sole proprietors are not required to apply for this type of business structure though, depending on their business or location, they may need to obtain a license. You can use this SBA portal to determine whether you’ll require a business license or permit. Those who choose to operate under a different name should file a DBA (Doing Business As) with their state or county clerk’s office as required. Doing so will permit you to receive checks and conduct operations under that name.
- Sole proprietors maintain complete control of their businesses.
- Sole proprietorships are easy to establish. Unless your business requires a license or permit to operate – or unless you choose to work under a fictitious name – simply have at it.
- Sole proprietors are liable for all business debts or obligations incurred.
- Bank loans are not always easy to obtain for sole proprietors.
- Sole proprietors cannot utilize stock offerings to raise money.
Tax Implications: Sole proprietors must pay self-employment tax and file a Schedule C. To learn more about the financial aspects of sole proprietorships, speak with your accountant or visit the IRS sole proprietorship webpage.
Partnerships are useful when there are two or more founders contributing to the company. To establish a partnership, you’ll need to register the business in your state, choose an operating name, file a DBA, and obtain any permits or licenses required by your industry or state.
For this sort of arrangement to work well, a partnership agreement should be drawn up and signed by all parties. It should include all expectations about day-to-day business operations, the manner in which decisions will be handled, how profits will be divided, and how the partnership can be terminated or amended. Failing to draft this document with the advice of a knowledgeable business attorney can lead to turmoil down the road. Because partners are all subject to personal liability for the business’ actions and obligations, it’s important that this document exist in order to help establish a strong foundation for all business activities.
There are three different types of partnerships: general partnerships, limited partnerships, and joint ventures. The first has equal distribution of liability, profits, and responsibilities unless noted in the partnership agreement. The second includes at least one partner with limited liability and limited control over the company. The third is a temporary partnership often utilized for a specific amount of time on a particular project.
- Sharing the responsibility of running a business can ease the stress that comes with entrepreneurship in addition to the financial burdens.
- Partners often bring different skill sets to the table. A good partnership is comprised of complementary skills and personalities to help the business thrive in its sector.
- Certain businesses, such as law firms, offer partnerships as an incentive to encourage hard work from junior employees.
- All partners may be held liable for the debts or obligations of a partnership.
- Lack of an operating agreement can lead to problems and infighting. To avoid this, make sure that each partner’s role is clearly defined and that all agreements are recorded on paper.
Tax Implications: Partnerships will require an employee identification number in order to operate and will need to file tax forms, though the business itself does not pay taxes. The tax burden, in addition to the profits and losses, are passed directly to partners. (IRS forms for Partnerships)
LLC: Limited Liability Company
A popular choice for many small businesses is the limited liability company or LLC. It may also be one of the most poorly understood business entities. While many people are aware that the owners of a limited liability company are not necessarily liable for the LLC’s losses or debts, the functional and tax implications are less well understood. Make sure to fully investigate the details of how your particular state – or the state in which you’re establishing your limited liability company – handles LLCs.
To establish an LLC, in addition to selecting a name, you’ll need to file your company’s Articles of Organization to provide basic information about the new company, such as its name, address, and members. You’ll need to obtain any required licenses/permits and create an operating agreement if mandated by your state. The latter is not widely required, though any business lawyer will impress upon you the importance of having decision-making and profit-sharing information formalized in a legal document. Some states require that LLCs announce their formation in a local paper. Because regulations vary, don’t neglect to check your state’s specific requirements!
- Limited personal liability for the members of an LLC.
- Generally less expensive to start than a corporation and requires less paperwork.
- Profits are divided as the members see fit, allowing the LLC to customize the percentage that each member receives.
- Members must each pay self-employment taxes and file appropriate forms.
- Depending on the structure and operating agreement, an LLC may dissolve when a member leaves. Consulting with a lawyer may help you to determine whether there are ways to enable the LLC to continue after a member has departed.
Tax Implications: LLC tax implications can be a bit tricky. Members much each pay self-employment tax. The LLC itself is not taxed by the federal government, though some states do tax LLCs. According to the Small Business Association (SBA), “…since an LLC is not recognized as a business entity for taxation purposes, all LLCs must file a corporation, partnership, or sole proprietorship tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law.” To better understand which forms your business may be required to file as an LLC, view the IRS’s LLC page. Additionally, LLCs can request S Corp status (discussed later) and be taxed as an corporation while maintaining an LLC’s structure and protections.
Owned by shareholders, a corporation is the most heavily regulated business structure. It is considered to be a tax-paying entity. Because of the expense of starting and running a corporation, the SBA suggests this type of structure for large companies which are already established and have multiple employees.
State regulations for establishing a new corporation vary, though most require a DBA and articles of incorporation to be filed. As with other structures, necessary licenses and permits vary by state and industry.
- Shareholders are not liable for business debts or obligations.
- Corporations can raise funds by selling stock.
- Corporations can offer stock as a benefit or payment option.
- Most expensive type of business structure to start.
- Owner/employees may be subject to double taxation.
- Heavy regulation leads to plenty of paperwork and record keeping.
Tax Implications: The IRS taxes corporations on their profits, as do states and some local governments. In explaining double taxation, the IRS states, “The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation.” Because of the regulations by which corporations must abide, you will definitely need to hire a capable business lawyer and accountant. The IRS specifies the forms that a corporation must file here.
Subchapter S Corporation
More commonly referred to as an S Corp, the subchapter S designation allows for additional individual tax savings vs. a C corporation.
To form an S Corp, a company must first complete corporation paperwork and file the S Corp election form, Form 2553, which must be signed by all shareholders. To be eligible, the corporation must be based in the United States and its shareholders must all be individuals, trusts, or estates. Other regulations are listed on the IRS S Corp website.
An LLC may elect to become an S Corp by filing Form 2553 as well, though filing must be done within 75 days of the tax year’s start. This enables an LLC to both maintain its legal status as an LLC and file taxes as an S Corp.
- Can provide tax savings for LLC owners because of the way in which profits are distributed.
- Does not end when a shareholder departs (unlike when a member leaves an LLC).
- More heavily regulated than an LLC.
- Can invite an audit if wages and distributions are not seen as fair or appropriate by the IRS.
Tax Implications: While C Corps are taxed twice, S Corps bypass the double taxation pitfall by passing on income, losses, deductions, and credits directly to shareholders. S Corps may still have to pay taxes on certain types of income, but shareholders are generally responsible for the bulk of taxes. States do not treat S Corps uniformly. Prior to opting for this designation, ascertain that it’s recognized in your state and that selecting it would be beneficial to your business.
Cooperatives are generally overlooked in business literature, as most companies won’t qualify for the designation. However, with the increase in Community Supported Agriculture (CSA) projects across the nation and the growth of interest in social entrepreneurship, I wanted to include this section for those who might be interested.
Cooperatives are organizations which are owned by their members. The members either help to produce the products sold by the cooperative or somehow assist in the cooperative’s operation. The members then split the profits. While some entrepreneurs may reflexively dismiss cooperatives as small organizations that sell fruit, there are some popular cooperatives of which many of us have heard, though possibly without knowledge of their corporate status. In fact, Ace Hardware is a cooperative – the world’s largest retail hardware cooperative. Others you might recognize include: Land O’Lakes, Cabot Creamery, Ocean Spray, and Welch’s.
To form a cooperative, members must first determine a common need and formulate a strategy. Once a business plan has been created, every member must agree with the plan. If a cooperative desires to incorporate, it will need to file articles of incorporation. Some states require bylaws, while others do not. A membership application process must be developed and a schedule of regular meetings should be established. Charter members must elect directors and OK all bylaws or changes in operations. Additionally, the cooperative must obtain appropriate permits or licenses as required by state or federal law for their industry or region.
Because the regulations vary by state, it’s a good idea to consult with a lawyer when forming a cooperative.
- Cooperatives are marked by the involvement of their members. Those employed by a cooperative have extra incentive to produce positive results.
- Unlike with an LLC, a departing member does not necessitate dissolution of the enterprise.
- New members can join at any time.
- The authority wielded by a particular member is not, of necessity, in proportion with the shares they own. (Some may consider this to be a con rather than a pro.)
- Certain grants are only available to cooperatives.
- Profits are not taxed at the cooperative level, but taxed at the individual member level.
- Because every member has the same amount of authority, those with substantial assets to invest may wish to look elsewhere.
- If members/workers don’t participate, then everyone suffers.
Tax Implications: Cooperatives are not taxed on their profits. They pass those along to their members, who are then each taxed on their individual incomes. Some cooperatives, like credit unions, are exempt from taxation. Currently, the IRS does not have a separate webpage for cooperatives. Rather, it has some information available regarding the various types of cooperatives, such as farmer’s cooperatives or retail cooperatives. For more information, you should speak with an accountant or lawyer.
What to Consider When Choosing a Business Structure
Choosing a business structure is an important part of establishing a business. Consult with your lawyer or accountant prior to making a decision. Additionally, keep the following in mind:
Depending on the type of business you’re operating, you may want to consider the level of liability with which you’re comfortable. To protect your personal assets, consider – in consultation with professional advisors – whether it might be advantageous to select a particular business structure.
Different business structures have correspondingly different taxation methods. For example, whereas a sole proprietor is responsible for paying self-employment taxes on all of his business’ net income, a C corporation employee is not.
The licenses and permits required to establish a company in a particular industry vary between states. When researching business structures, identify the paperwork requirements and the filing costs for your particular business. A lawyer knowledgeable in your industry may be able to assist with this task.
What level of flexibility does your business require? As you’re researching business structures, keep this point in mind and ensure that the structure you choose enables you to run your business in a manner that affords you the greatest likelihood of success.
Consider your company’s goals when deciding on its structure. For example, if you envision a need to raise capital at some point in the future, you should structure the company to facilitate that eventuality. Every entrepreneur is different and every business has different needs. There is no one-size-fits-all solution.
Can you change from one business structure to another?
It is possible to change business structures after you’ve already begun operations. If changes in your business appear to require a change of structure, first determine the type of structure to which you’d like to change and then speak to your accountant or lawyer in order to ensure that the proposed change makes sense for your business. They’ll inform you of the paperwork to file, such as a DBA or articles of incorporation, in order to establish your business under the new structure. If you don’t have shareholders, this will be much easier to accomplish. Because shareholders have the potential to complicate the restructuring process tremendously, it’s important to thoroughly research structures when first starting a business and to look toward the future from the initial planning phase.
Selecting the appropriate business structure can have important implications for your company’s financial and legal future. Unless you’re already well-versed in the different structures and have a complete understanding of each structure’s range of ramifications, strongly consider consultation with an experienced legal or financial professional.
About the Author
Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).
Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.
Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.