When starting a new business, one must carefully choose a business structure to make it a legal entity, which means that it can own property, own bank accounts, and pay taxes the same way that an individual person would. When contemplating which business structure to choose, one must weight the pros and cons as they all have different features.
A sole proprietorship is usually owned by a single person or a couple. With this business structure, the owner is personally liable for all business debts, can freely transfer the business assets, and report all taxes under personal income. This entity is good in its simplicity and lack of restrictions. However, it comes with a severe drawback of potentially being personally liable for all damages that a business may incur.
In recent times, Limited Liability Companies have become very popular, as they combine the limited legal liability of full corporations but have easier tax structures like sole proprietorships and partnerships. LLCs are powerful because they protect owners from the present and future debts of the business. They also provide tax benefits of pass-through business losses that can offset the owner’s other nonbusiness income and distribution of profit that can be taxed at the owner’s potentially lower marginal tax bracket.
In addition, if a business has multiple owners, it can operate as an LLC while electing for its tax structure to be treated as a corporate entity. If the owners of the LLC want to retain profits within the business to facilitate growth of the business, the recommended option is a C corporation tax election, where the LLC’s profits are only subject to the beginning corporate tax rate of 15%, which is usually less than the personal marginal tax rates of individual owners. And if any of the owners wish to receive compensation, they can be paid W-2 wages for their work within this structure. However, if the owners prefer to withdraw substantial profits from business, the recommended option is the S Corporation election. This allows each owner to receive a pro rated share of the LLC’s total profit as distributions that would be personally taxed at each owner’s marginal tax rate. Furthermore, these distributions are not subject to Self-Employment Tax.
With general partnerships, partners share income and managerial duties, while each partner is personally liable for any debt. Members of general partnerships must file an informational tax return and file personal income taxes. General partnerships are the most simple business structure to form, as they only require that at least two people agree to be partners or conduct business and share profits even with an express agreement. They do not have to register or file organizational documents but usually must register a trade name unless the business operates under the names of the partners.
Corporations are complex structures with high legal costs. They are owned through stock and have complicated tax, licensing and regulation requirements. They must also follow complex procedures such as issuing stock certificates, holding annual meetings and keeping minutes, electing directors, and so on.
C-Corporations are distinct legal entities that are taxed separately from the owners and generally are not advised to own assets that appreciate in value. While they do protect against personal liability, they have some disadvantages with regards to taxes and operations when compared to an LLC or limited partnership. However, they may have lower tax rates if annual net income is below $75,000. S-Corporations protect their owners against personal liability and are not taxed as a separate legal entity. They have limitations on the number and type of eligible shareholders and have some tax and operating disadvantages when compared to an LLC.
When choosing a business structure, it is important to consult a tax accountant or attorney to make sure that one understands all the pros and cons behind the decision and makes the correct elections based on the situation. This decision should be based on a multitude of factors, including the type of business, the tax structure and benefits desired, who the owners of the business are, and the amount of capital and budget available to spend on a particular business structure.