Starting your own business is thrilling, not to mention liberating. You become your own boss, do what you love, and make money while doing it. Once you have your product or service solidified, getting your business off the ground is no small task. While registering your business and deciding which insurance you need, you also must decide on a Business Structure.

There’s more than one way to structure your business. It is important you keep in mind things like liability, taxes, flexibility, and cost when choosing your business structure. Which business structure best fits your needs and goals? By the end of this article, you’ll have a better understanding of which structure is most conducive to your work.

Types of Business Structures:

Sole Proprietorship

Sole proprietorships are the easiest and most common business structures. You may also hear a sole proprietorship referred to as a sole trader or a proprietorship.

As an unincorporated business, the individual owner pays personal income tax on profits earned. The business income and expenses are reported in the same personal tax return as your other income and deductions. There is no distinction between you and the business you own. This type of business is popular among sole business owners, self-contractors, and consultants for the simplicity of operation and tax reporting.

Being solely responsible for the business, you are entitled to all profits. You are then responsible for any business debts, losses, and liabilities. However, you do get to enjoy limited government regulation.

Though, there is an important distinction to make here. Say you are the sole member of a domestic limited liability company (LLC). You are not a sole proprietor if you elect to treat the LLC as a corporation. More on this later.

Partnerships

A partnership forms when two or more people or entities join together to manage business operations and share profits and liabilities. There are two different kinds of partnerships, general and limited. And in a limited partnership, there are two types of partners, general and limited. Lots of two’s.

In a general partnership, you work as co-owner with the other partner(s). All partners share both profits and liabilities. In a partnership, the partnership does not pay taxes; instead; you and your partner(s) will be taxed at your personal level on your share of the profit. If you choose to pursue this business structure, consider drawing up a partnership agreement to define specific shares for each of the partners.

In a limited partnership, one or more partners are not involved in the daily operations of the business. This is sometimes called a “silent partner.” For example, many real estate partnerships are often formed as limited liability partnerships. Consider the limited partner more akin to investors of the business. They share ownership without the risk or responsibility

Whether general or limited partnership, the profits are reported as income in the personal tax return of the individual partners. The partnership does not pay income tax. But, the partnership does file an income tax return and reports its income annually to its partners so they know what to include in their personal tax returns.

Corporation or C-Corp

A corporation is a legal entity that is separate and distinct from its owners. C-Corps are subject to a corporate income tax under Subchapter C of the Internal Revenue Code. The taxing of profits in a C-Corporation can create a double tax situation - once at the corporate level, and then a second time at the personal level. This is one of the perceived disadvantages of a C corporation.

Corporations share similar rights and responsibilities that individuals have. They can enter contracts, loan and borrow money, sue and be sued, hire employees, own assets, and pay taxes. Keep in mind, C-corporations are required to hold annual meetings and have a board of directors that is voted on by shareholders. This very formal structure, and documenting such, is another disadvantage.

One of the key advantages of a C-Corporation is that it separates or shields owners' or shareholders' assets from liabilities of the corporation. In this way, C-Corps limit the liability of investors and firm owners. The most they can lose in the business's failure is the amount they have invested in it.

Although the C corporation can result in double taxation, there are certain tax scenarios where it is preferred: high growth companies may be able to exclude large amounts of gain on the sale of the business, and in a situation where the corporation will not be able to distribute profits, then paying tax at the corporate level makes sense.

S-Corporation or S-Corp

An S-Corporation (derived from Subchapter S of the Internal Revenue Code) is also known simply as an S-Corp. S-Corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. (this is much like the pass-through of income from a partnership or proprietorship, where the income is taxed to the owner(s)). A corporation with 100 shareholders or less can enjoy incorporation while being taxed like a partnership. Generally, electing Subchapter S avoids the double taxation disadvantage.

To qualify for S-Corporation status, your corporation must meet the following requirements:

Be a domestic corporation
Have only allowable shareholders (individuals, specific trusts and estates, or certain tax-exempt organizations)
Have no more than 100 shareholders
Shareholders may not be partnerships, corporations, or non-resident alien shareholders
Have only one class of stock
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

Limited Liability Company

An LLC is a more formal legal arrangement offering limited liability much like corporations. It requires a legal document called articles of organization to be filed with the state. The law surrounding limited liability companies (LLCs) varies from state to state.

Owners of LLCs are called members. There is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner. These members are not personally liable for the company's debts or liabilities. Many states don't restrict ownership so anyone can be a member. Though, some entities cannot form LLCs, like banks and insurance companies. Check your state’s requirements for further information.

You can form an LLC for your proprietorship, and it will be taxed in the same manner as the proprietorship discussed above. Additionally, an LLC may be owned by two or more members, in which case it will be treated for tax purposes like a partnership.

And just to keep you on your toes, we can file an election to treat an LLC as either an S corporation or a C corporation!

We really like the attributes of an LLC, particularly when starting out a new business.

By the Numbers

Just in case you are curious, based upon the most recent data available from the IRS, here is how businesses are organized:

C Corporations 1.6 million

S Corporation 4.5 million

Partnerships:

General 0.6 million

Limited 0.4 million

LLCs 2.5 million

Proprietorships

(excluding farms

Including single-

member LLCs) 25.2 million

The numbers tell a story. An entity that limits liability, and passes through income, seems to be the winner - LLCs and S-Corps. We are betting that many of the proprietorships are single-member LLCs.

Dig Deeper

One of our research partners, Bradford Tax Institute, has prepared an incredibly detailed resource detailing the major attributes involved in entity selection, and you can download the PDF here.

Bottom Line

You’ve got the drive and the motivation to take your business idea to the next level. Once you’ve decided on your business structure, you’re ready to officially register your business with your state. Make that journey easier with an experienced business coach on your side.

As Gazelles Scaling Up Certified Coaches, we empower you with strategic tools to help your business flourish. We become your trusted advisor and sounding board.

Holden Moss CPAs is dedicated to aiding businesses in this difficult time. If you have any questions about starting your own business or are seeking coaching for an established business, give us a call at (919) 556-6216. You can also contact us via email at admin@holdenmoss.com. We look forward to working with you.

Resources:

“Sole Proprietorships,” Internal Revenue Service, accessed March, 2021

https://www.irs.gov/businesses/small-businesses-self-employed/sole-proprietorships.

“Limited Liability Company (LLC),” Internal Revenue Service, access March, 2021

https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc.

“S Corporations,” Internal Revenue Service, accessed March, 2021

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations.

Which Business Structure is the Best Fit for You?