What business structure should I choose?
Roshani Pandey is a financial advisor and founder of True Root Financial. True Root Financial is located in San Francisco, CA and serves clients across the globe.
According to the Census Bureau, the pandemic has created a boom in new business start-ups. A record 4.3 million new businesses filed paperwork to start in the last two years, a 24% increase from the prior year.
If your new year’s resolution is to start a new business, choosing the right business structure is the key first step. If you already have a business, reviewing the business structure to make sure it is still right for you, should be a key goal this year.
Business Structure Options and Considerations
Business owners who might be wondering what business structure should I choose, typically have 5 choices: sole proprietorship, general partnership, limited partnership, limited liability company (LLC), C corporation, and S corporation.
For many businesses, taxes are a primary consideration when choosing a business entity. While taxes are certainly very important, other factors such as legal liability, administrative costs as well as the future of the business are also important considerations.
Sole proprietorship
As the name suggests, sole proprietorships have one owner and as such, all the business profits pass to the sole proprietor’s tax return. You are automatically deemed to be a sole proprietorship if you conduct business activities but do not register as any other kind of business.
Advantages
The biggest advantage of sole proprietorships is its simplicity. There is no need for major corporate formalities or paperwork requirements, such as meeting minutes, bylaws, etc.
Disadvantages
The simple structure of the entity means that there is no separation between the owner and the business. This creates risks for the owner as the assets and the liabilities of the business are not independent of your personal assets and liabilities.
Partnership
A partnership is a simple way for multiple owners to own a business. It is an unincorporated business owned by multiple owners, people, or other businesses. The partners divide the profits amongst themselves and report it on their tax returns. There are generally two types of partnerships – general partnerships, limited partnerships, limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs).
Limited partnerships are quite common with hedge funds and private equity or venture funds. The hedge fund manager or the venture fund manager is often the general partner with unlimited liability, while the investors come in as limited partners, with limited liability and limited control over the fund. These arrangements are disclosed in the partnership agreement. Profits are passed through to personal tax returns, and the general partner is also on the hook for self-employment taxes.
Limited liability partnerships are similar to limited partnerships but grant limited liability to every owner. An LLP protects each partner from debts against the partnerships, and they won’t be responsible for the actions of other partners.
Advantages
Partnerships can be a good choice for businesses with several owners, professional groups (such as attorneys), and groups who want to try out their business idea before forming a corporation.
Disadvantages
Partnerships are straightforward but do not provide as many opportunities for tax planning as corporations do.
Limited Liability Company (LLC)
An LLC is a blended business structure that caps the personal liability of its owners — the members — like a corporation but allows taxation of the profits on either a member level or the corporate level.
As the name suggests, LLCs protect you from personal liability in most cases. Generally, your personal assets such as your bank accounts will remain separate from your business assets and liabilities in the case of bankruptcy or lawsuit.
Profits and losses can also be distributed to the LLC members without facing corporate taxes. If you’re self-employed, you can also open a “single-member” LLC as the owner and have the business profits pass through to your personal income tax, just like you would as a sole proprietorship. However, unlike a sole proprietorship, an LLC would provide you with some liability protection, where you would not be personally liable for the business.
Advantages
LLCs are very easy to set up. You can set one up online. For this reason, many small business owners form an LLC when starting a business. It also permits you to take advantage of the benefits of a corporate structure, where your personal assets are separate from the business assets and liabilities.
Disadvantages
You have to register an LLC with your state. In some states like California, the state registration fee can be expensive. Additionally, states might have additional requirements to ensure that the LLC is in good standing. So, compared to a sole proprietorship, LLCs require a little more maintenance.
Corporation (C Corp)
A corporation, sometimes called a C corp, is a legal entity that is separate from its owners. Shareholders are the owners of the company. They together with the board of directors and officers run the company.
Advantages
Corporations offer the most robust protection to their owners from personal liability. Corporations have a completely independent life separate from their shareholders. If a shareholder leaves the company or sells his or her shares, the C corp can continue business operations relatively undisturbed.
Another advantage is that corporations can raise capital by selling stock, which can also help to attract top talent.
Corporations can be a good choice for medium- or higher-risk businesses. They can also be advisable for enterprises that need to solicit funds from venture capital funds or through an IPO, and companies that plan to be sold eventually.
Disadvantages
Profits of C corporations are generally taxed twice – first, the company pays tax on its earnings, second shareholders pay tax when they receive dividends. However, the tax code offers some large deductions to a C Corp like the qualified small business stock (QSBS) deduction that can be very valuable. So, be sure to run a projection with a tax advisor before deciding if a C corp is right for your business or not.
Another disadvantage of a C Corp is that it can be expensive to set up. Corporations also require more extensive record-keeping, operational processes, and reporting.
S Corp
An S corporation is basically a corporation. But unlike a C corporation, it has elected to be taxed as a Scorp. An LLC can also make a Scorp election and choose to be taxed as one.
A Scorp is a flow-through entity, where the income and losses of the company are passed through to its owners. Shareholders of an S corp report the flow-through of income and losses on their personal tax returns and are taxed at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income in contrast to the C corp.
To form a Scorp, you must make a Scorp election with the IRS. An S corp can have only one class of stock. It is also limited to 100 shareholders, none of whom can be another for-profit business or a person without a green card who doesn’t meet IRS residency requirements. An S corp still has to meet the terms of corporate formalities, such as creating bylaws and holding board and shareholder meetings.
Not all states tax S corps similarly, but most recognize them as the federal government does and tax the shareholders correspondingly. Some states tax S corps on profits above an indicated limit. However, a few states do not recognize the S corp election, considering the business a C corp.
Advantages
A Scorp avoids the double taxation that affects C Corps. It can also lower taxes for self-employed individuals by allowing them to reduce their self-employment taxes.
Disadvantages
A Scorp has filing requirements with both the state as well as the IRS that must be adhered to. It may also have more administrative costs such as payroll and other bookkeeping costs compared to a simple LLC.
Taking the next step
A financial advisor who understands your goals and your overall financial picture can help you determine the business structure that’s right for you. They can also collaborate with a tax advisor to evaluate the tax savings from each structure and help you choose the right one.
Once you start the business, it becomes important to balance the needs and growth of the business with your personal financial goals and needs. Here again, a financial advisor can help you achieve both of these priorities. If you would like to understand how working with a financial advisor can help you, please book a call below:
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