Your Quick Guide to Business Structures
Once you get your business up and running, you’ll quickly discover a world of legal matters you have to handle to optimize your company.
One of these is picking a business structure.
Choosing a legal structure can be a tough choice for new business owners who aren’t well-versed on the ins and outs of business law and taxation.
Putting off choosing your legal structure can have dire consequences later on, though, including losing out on revenue, overpaying on taxes, or even facing personal debt liability.
Ultimately, you should consult a lawyer if you have in-depth law questions. However, we wanted to get you started, so we put together this quick guide to common business structures.
Why Should You Create a Formal Business Structure?
Most legal structures offer liability protection in case your firm is sued or owes debt. That means that, in most cases, those suing you or pursuing debts from you can’t seize any of your personal assets — only those that belong to the business.
For example, imagine you’re sued without a business structure. Assuming the damages are enough, the court may be allowed to order the seizure of assets like your vehicle or even your home.
However, with the proper business structure, only your business’ assets — such as bank accounts or equipment — are up for seizure.
That said, judges may throw out your liability protection (called piercing the corporate veil) if they think there’s no real separation between the business and your personal matters (among other situations). In this case, your business structure won’t protect you.
Whether you’re issuing equity to investors or seeking a loan from a bank, you’ll have a tough time getting the funding you need without a legal structure.
Institutions and investors alike prefer to see legal structure as it implies you’re serious about the business and things are more stable. The legal protections are also a plus in your funders’ eyes.
Any business structure is better than none, but as you’ll see, investors and institutions take some more seriously than others.
Some legal structures offer tax-beneficial ways to structure how you pay out your profits to yourself (and others if they’re involved). Once you’re earning a certain level of revenue, these can add up to massive savings.
Remember that you’ll likely need to provide your Employer Identification Number (EIN), not your Social Security number, when filing your business taxes.
Types of Business Structures in the US
Choosing the best legal structure for your firm requires you to reevaluate your goals and make yourself aware of all applicable laws and regulations. Fortunately, you can change your structure later if needed, but it always helps to get started on the right foot.
Additionally, it’s worth noting that you can often create a legal entity in a state that isn’t your home state. However, that might be a conversation you want to have with a business lawyer as it’s beyond the scope of this article.
With these things in mind, let’s compare the types of business structures available to you.
“Sole proprietorship” is the default structure the IRS hands to your business. It’s not a true legal structure, but it exists so the IRS has a tax classification for you.
Sole proprietorships are common for freelancers early in their careers, given the simplicity of their business. Some product businesses may also exist as a sole proprietorship for a while. Regardless, you can only be a sole proprietor if you don’t have employees.
Advantages of sole proprietorships
- Cost: There are no filing fees or other costs required to be a sole proprietor.
- Simplicity: Sole proprietors don’t have any special legal paperwork to file.
- Taxes: Income flows through to your personal return, so you’re only taxed once — at your individual rate.
Disadvantages of sole proprietorships
- No legal liability protection: Courts can come for personal assets like your home or vehicle if you’re successfully sued. Creditors may be able to do the same in some instances.
- Raising capital: Both lenders and investors prefer you have a formal legal structure.
- Client/customer troubles: Prospective clients or customers may not take you as seriously without a formal structure.
Limited Liability Company (LLC)
LLC is the simplest formal legal structure, although each US state has different laws surrounding the formation and maintenance of an LLC. They combine advantages from corporations and sole proprietorships.
LLCs run by a single person are called single-member LLCs, whereas LLCs with two or more owners are called partnerships.
But it goes even further. There are two types of partnerships.
- General partnerships: All partners manage the business, share in profits and losses, and assume responsibilities for debts.
- Limited partnerships: Has at least one general and one limited partner. The limited partner is essentially just an investor and doesn’t participate in business operations as a general partner would.
Advantages of LLCs
- Inexpensive and easy to form: Despite rules varying between states, LLCs require much less paperwork than corporations. Filing fees are often minimal, too. For example, filing for an LLC in Michigan costs no more than $100 (and that’s for priority rush filing).
- Liability protection: LLCs generally protect personal assets from seizure in lawsuits and similar matters.
- Flexibility: LLCs generally don’t come with strict requirements about who can be in management.
- Taxes: LLCs also get pass-through treatment. Your income flows through to your personal return for taxation.
Disadvantages of LLCs
- Varying requirements: Every state sets its own LLC rules, and some are stricter than others. You’ll have to understand the laws of the state in which you’d like to start your LLC.
- Piercing the corporate veil: In some instances, a court may determine that your liability protections don't count.
- Potential additional taxes: Some states may levy additional taxes on LLCs, such as franchise taxes.
A C-corporation is what you think about when you hear “corporation.” It separates ownership from management. C-corps have shareholders and a Board of Directors that gets to vote on various corporate decisions.
Advantages of C-corporations
- Raising funds: C-corps must issue stock. By doing this, however, they raise a lot of capital quickly. Plus, investors prefer C-corps due to the more formal status.
- Tax planning: C-corps taxation is a double-edged sword. On the plus side, you can structure your income between salaries and distributions to get better tax treatment.
- Perpetual existence: The C-corp is a separate legal entity, so it stays there after you die unless you or someone else closes the business.
Disadvantages of C-corporations
- Double taxation: On the other side of the taxation issue, C-corps face double taxation. The corporation’s earnings are taxed at the corporate rate, then the distributions to shareholders are taxed at each shareholder’s personal rate. This also means C-corps file a separate return aside from each shareholder’s Form 1040.
- Complexity and tasks: C-corps must make annual filings, hold shareholder meetings, and provide reports to shareholders.
- Limited protection: Corporation must be properly “capitalized” to give shareholders appropriate protection. That means the firm must have enough capital to back up its treatment as a separate legal entity.
Finally, S-corps aren’t truly their own business structure. Instead, they’re a special tax treatment allowed by Subchapter S of IRC Chapter 1 that LLCs and C-corporations can opt to file as if they meet specific IRS requirements. To become an S-corp, you must meet these requirements, then file Form 2553. If the IRS approves your S-corp status, you’ll receive a letter from the IRS (CP261) about 60 days after filing Form 2553 to indicate your approval as an S-Corp.
Advantages of S-corporations
- Pass-through entity: S-corps do not experience double taxation, making it advantageous for C-corps.
- Payment structure: S-corps pay shareholders a salary, meaning payroll taxes — which may count as business expenses for the corporation. The rest can be paid out as distributions, which avoid payroll taxes.
- Temporary: You can change to another taxation method as long as you file a written statement — signed by more than 50% of the shareholders — stating that you’d like to do so.
Disadvantages of S-corporations
- Strict requirements: Given the favorable tax treatment, the IRS has strict requirements for qualifying as an S-corp.
- Increased IRS scrutiny: With stricter requirements comes stricter IRS scrutiny. The IRS will watch you more closely and will swiftly remove your S-corp status if you fail to comply with the requirements.
- Compensation requirements: Any salary you pay per S-corp rules must be “reasonable”. If you try to get around this by paying a significantly lower salary (based on the market and other factors) and pay the rest as distributions, the IRS can reclassify the distributions and wages, meaning more taxes for you.
Structure Your Business For Success
Each legal structure has its benefits and drawbacks. Ultimately, this is an issue to handle with a lawyer specializing in business law. Your CPA can also provide guidance if you work with one.
That said, you can point yourself in the right direction before working with one of these professionals by looking at your overall books and seeing how complex your business is. For that, a solution like ZarMoney will do the trick for you.
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