Money Smarts Blog

As you start putting together your business plan, one of the most important choices you will need to make is what type of legal structure fits your business. The structure of the company can have a significant impact on many things, including your taxes, compensation, and insurance.

Here’s a high-level overview of the more common business structures, but we recommend consulting with business counselors (like SCORE), attorneys, and accountants to fully understand the many nuances of the different structures.

You may not know exactly where to start, so think about the following questions:

• Do you need to protect your personal assets from the risk of your business? (liability protection)
• How do you want to pay taxes?
• What are your financing needs and options?
• How much administrative complexity can you deal with?

There are many other issues to consider, but as you read on you’ll see the main differences between the different business types deal with these areas. 

Sole Proprietorship

If the taxpayer is a sole business owner or professional in their own practice, they’re usually practicing as a sole proprietor. In this type of entity, you report business profit or loss on your personal tax return.

Advantages:

• Cost to set-up is minimal
• Documentation to file is simple and there are no state fees
• Business income is taxed only once as personal income

Disadvantages:

• No distinction between business and personal assets, meaning no liability protection
• Subject to self-employment tax
  

Partnership

The simplest structure for two or more people (who aren’t married) to own a business together is a partnership. There are three common kinds of partnerships: general partnership (GP), limited partnerships (LP) and limited liability partnerships (LLP).

In a general partnership, all parties share the legal and financial liability of the partnership equally. Limited partnerships have only one general partner with unlimited liability, and all other partners have limited liability. Limited liability partnerships are like limited partnerships, but give limited liability to every owner. 

Advantages:

• Flexible structure
• Business income is taxed only once as personal income
• For a GP, creation is simple and set-up costs are low
• For an LP, liability shared between limited and general partners
• For an LLP, personal assets are protected

Disadvantages:

• Subject to self-employment tax
• No liability protection of personal assets in a GP
• In an LP, the General Partner’s liability is unlimited

Partnerships can be a good choice for businesses with multiple owners, professional groups (like attorneys), and groups who want to test their business idea before forming a more formal business.

Limited Liability Company (LLC)

A Limited Liability Company structure combines the benefits of both the corporation and partnership business structures. In the LLC structure the members of the company are not personally liable for the company's debts or liabilities, like a corporation. In addition, the ability to have profits taxed once as personal income is a feature of partnerships.

Profits and losses can get passed through to your personal income without facing corporate taxes. However, members of an LLC are considered self-employed and must pay self-employment tax contributions toward Medicare and Social Security.

Advantages:

• Shields owners from personal liability
• Business income is taxed only once as personal income
• Fewer formal administrative and compliance requirements than a corporation

Disadvantages:

• Can cost as much as an S corporation to set-up
• Requires separate tax return for the LLC
• Members may be taxed on profits that aren’t distributed
• Business continuation agreement needed to ensure smooth transfer of ownership and avoid dissolution

LLCs can be a good choice for medium- or higher-risk businesses, owners with significant personal assets they want to be protected, and owners who want to pay a lower tax rate than they would with a corporation.

Corporation – C Corp

A corporation is a legal entity that is separate and distinct from its owners. Corporations enjoy most of the rights and responsibilities that an individual possesses; that is, a corporation has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes.

Incorporating your business automatically makes you a regular or “C” corporation. A C Corp is a legal entity, with a charter granted by the state in which it is headquartered. It can sell shares of stock to raise money, and shareholders become owners with an interest based on the size of their investments.

Advantages:

• The corporation is liable for the company’s obligations, not its shareholders
• Tax-free benefits, such as insurance, travel, and retirement plan deductions
• Transfer of ownership facilitated by the sale of stock
• Change of ownership need not affect management
• Ability to raise capital through the sale of stock and bonds

Disadvantages:

• High cost to start-up and documentation is complex
• Government oversight and more regulations
• Often requires specialized personnel to deal with tax, accounting, and HR issues that demand compliance
• Profits are taxed twice, both at the corporate and individual level

Corporations can be a good choice for medium- or higher-risk businesses, businesses that need to raise money, and businesses that plan to "go public" or eventually be sold.

Corporation - S Corp

An S corporation, sometimes called an S corp, is a special type of corporation that's designed to avoid the double taxation drawback of regular C corps. S corps allow profits, and some losses, to be passed through directly to owners' personal income without ever being subject to corporate tax rates.

Not all states tax S corps equally, but most recognize them the same way the federal government does and taxes the shareholders accordingly. Some states tax S corps on profits above a specified limit and other states don't recognize the S corp election at all, simply treating the business as a C corp.

Advantages:

• Business income is taxed only once as personal income
• The corporation is liable for the company’s obligations, not its shareholders
• Tax-free benefits, such as insurance, travel, and retirement plan deductions
• Transfer of ownership facilitated by the sale of stock
• Change of ownership need not affect management
• Ability to raise capital through the sale of stock and bonds

Disadvantages:

• Limited to 100 shareholders and excludes ownership by foreigners and other corporations
• Only one class of stock permitted
• High cost to start-up and documentation is complex
• Government oversight and more regulations
• Often requires specialized personnel to deal with tax, accounting, and HR issues that demand compliance

S corps can be a good choice for a business that would otherwise be a C corp, but meet the criteria to file as an S corp.

The business structures mentioned above are some of the most common we come across in the commercial lending world, but there are other options available as well. Again, it’s important to consult with business counselors (like SCORE), attorneys, and accountants as regulations for starting a company differ from state to state. Consulting the experts can help avoid unintended consequences down the road.