Selecting Your Business Structure

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This page is dedicated to helping you select the best structure for your business. Below is a comparison of the most common business structures and corresponding tax treatments.

Shortcut for Small Businesses

If you're starting a small business, you just discovered the shortcut through the overwhelming array of legal vocabulary and tax options in choosing your business structure. 90% of small businesses only need to consider two options:

  1. a sole proprietorship (one owner) or a general partnership (many owners), or
  2. a limited liability company

These structures are inexpensive to start, easy to run, and permit you to save money on taxes with pass-through taxation.

By small business, we mean companies with just one or only a few owners. This includes mom-and-pop shops, retail stores, consumer services, and business-to-business services.

Here's why the other structures you may have heard about don't make much sense to a new small business:

  • LPs, LLPs, and other partnerships are generally used by attorneys, accountants, real estate agents, and other professionals.
  • A corporation is typically used for more complex ownership and investment structures. The many formalities of running a corporation make sense when a lot of owners and investors are working together. What about the benefits of S-Corp tax treatment, you ask? An LLC can be taxed as an S-Corp... read on!

Overview of Small Business Structures

Start with a business structure that is inexpensive and easy to run and change later if need be.

short cut road
Sole Proprietorship/General Partnership Limited Liability Company (LLC)

Summary

These structures are the fastest and most affordable way to get up and running - the paperwork is minimal. The biggest drawback (and a very important one) is that these structures do not provide limited liability. We form more LLCs than any other business structure. Their popularity is for good reason. LLCs combine the liability protections of corporations with the pass-through taxation available to sole proprietors and partnerships.

Control

Owners have total control of business operations and profits. Partners define the management and profit-sharing of the business in a document called the Partnership Agreement. An LLC is owned by members. They usually receive profits according to their percentage ownership. The members can manage the LLC themselves or declare the LLC “manager-managed” and appoint managers. The LLC writes an Operating Agreement which defines how the business holds meetings, may add owners, and otherwise runs itself.

Limited Liability

No. The owner's personal assets are at risk. Yes. Members are protected from the liabilities of the business.

Taxation

Income or loss is passed through to the owners. Most small businesses start with pass-through taxation (the same as a sole proprietorship or partnership). The LLC may make a special election to be taxed as an S-Corp or C-Corp, which can help save on taxes as the business grows.

The Thought Process

Most of our small business start-ups have the same thought process. Here is how we break it down.

Thought #1: Your Business Name

Does your business name include your legal last name? If not, your state likely requires you to register your business name.

Let's use the example of John Doe, who is ready to take his passion for flamingo lawn ornaments and turn it into a business. He would not need to register the name "John Doe's Lawn Ornaments" because it includes his legal name. But he would need to register "Flamingoes Galore Lawn Ornaments" since it doesn't.

To fulfill the requirement to register a business name, you can register either a fictitious name (to start a sole proprietorship or general partnership) or file the formation document for an LLC or other business entity.

Thought #2: The Importance of Liability Protection

Registering a business entity (such as an LLC) provides the added benefit of limited liability. Limited liability is what protects your personal assets if the business gets into debt or is sued. Your home, car, retirement account, and children's college funds stay yours.

Limited liability should be the chief concern for most owners. Often it is not until owners discuss their risks that they realize their exposure. Any business with a physical location, employees, or that sells a product or service that might malfunction (e.g. food poisoning) has liability risk.

A common misconception is that you don't need limited liability if you purchase liability insurance. The difference is this: liability insurance protects the assets of the business while a limited liability entity protects the assets of the owners. Furthermore, liability insurance can exclude coverage and set policy limits.

Thought #3: Comparing Costs and Effort

An LLC is probably not as expensive or time-consuming as you think, compared to running a sole proprietorship or partnership. many of your basic business practices and fees will be the same.

limited liability wall

Limited liability separates the risk that your business gets into debt or is sued from impacting your personal finances.

An LLC may be easier than you think:

  • Depending on your state, the fee to form an LLC may be less, the same, or slightly more than the fee to register a doing business as (DBA) name. For example, in Pennsylvania a fictitious name costs $270 (due to publishing fees) and an LLC costs $125.
  • Regardless of which business structure you choose, you should be running your business as a business. This means keeping separate finances for your business, signing contracts under the business instead of your personal name, and other day-to-day basic business behaviors.
  • Many accountants do not charge extra to file your taxes as an LLC. They need to prepare many of the same forms and schedules. By default, an LLC receives pass-through taxation so it will be identical to the taxation you would receive as a sole proprietorship or general partnership.

The extra effort of an LLC:

  • Running an LLC means that you should hold an annual meeting. If it's just you, have a meeting with yourself. Take yourself and your business partners out to lunch (on the business), discuss your performance in the past year and plans for the next year, and write meeting minutes for your LLC records.
  • Some states charge an annual fee to run an LLC and some do not.

Thought #4: Form your business in the state where you live and work

There is a lot of hype about registering your business in another state such as Delaware. The catch is that if you register your business in another state, you also have to register in your home state. So you would have to pay the expense of setting up and running two business entities.

This concept is called foreign qualifying. When you form your business, you will be authorized to do business in the state where your business is registered. When you're ready to start regularly transacting business in another state, you will need to "foreign quality" in that state to register your business in those borders.

Thought #5: Most small businesses save money with pass-through taxation

Pass-through taxation means that your business profits, losses, credits, and deductions "pass through" to your personal income tax returns. At the end of the year, you simply add your business income to your personal income then pay all taxes at your personal income tax rate. A sole proprietorship, general partnership, and LLC all receive pass-through taxation by default. In general, an LLC can save on taxes when profits exceed ~$75,000 per year per owner by electing S-Corp taxation.

home is where your business is

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Entity Selection for Businesses

Medium-to-large sized businesses have to navigate both the legal and tax implications of choosing a business structure.

First, let's clarify the vocabulary. The following chart shows legal structures and the taxation options available to them:

This means, for example, that if you decide you want to be taxed as an S-Corp, you still have the option of structuring your business as either an LLC or a corporation. It helps to consider your legal structure and desired taxation independently, then refer back to this chart to see if your desired combination is available.

Choosing a Legal Structure

Partnership
(GP, LP, or LLP)
LLC Corporation
(C-Corp or S-Corp)

Summary

These structures are a common option for professionals such as attorneys and accountants, especially in states where professionals are restricted from an LLC or corporation and still seek limited liability. We form more LLCs than any other business structure. Their popularity is for good reason. LLCs combine the liability protections of corporations with the pass-through taxation available to sole proprietors and partnerships. Businesses that will immediately earn substantial revenue or involve complex ownership arrangements typically consider a corporation or an LLC taxed as a corporation. C-Corp and S-Corp refer to two tax elections that can be made for either an LLC or a corporation.

Control

Owners in a GP and LLP have total control of business operations and profits. Only active owners in an LP may exercise control. Partners define their management and profit-sharing in their Partnership Agreement. An LLC is owned by members who receive profits per their ownership percentage or as defined in the Operating Agreement. The members can manage the LLC themselves or declare the LLC “manager-managed” and appoint managers. Most often a corporation issues stock to shareholders who invest in the corporation in anticipation of profit. Shareholders elect a board of directors to oversee the corporation. The directors appoint officers who run the corporation day-to-day. In smaller corporations, one person may hold multiple positions.

Limited Liability

GP: None.
LP: Limited partners may only act as investors. General partners may participate in management decisions but lack liability protection.
LLP: Generally speaking, partners in an LLP are shielded from debts, obligations, and liabilities resulting from another partner's negligence, malpractice, or misconduct.
Yes. Members are protected from the liabilities of the business. Yes. Shareholders, officers, and directors are protected from the liabilities of the business.

Taxation

The business is taxed as a partnership. Income or loss is passed through to the owners. Most small businesses start with pass-through taxation (the same as a sole proprietorship or partnership). The LLC may make a special election to be taxed as an S-Corp or C-Corp, which helps save on taxes as the business grows. By default, the corporation is taxed as a C-Corp. This results in double taxation of corporate profit and distributions to shareholders. Many small businesses choose to elect S-Corp taxation so the corporation is taxed as a pass-through entity (like a partnership).

Other Legal Structures

Professional
Attorneys, doctors, accountants, and other licensed professionals are restricted in which legal entities they are permitted to form. Restrictions vary by state and options often include a professional corporation, professional LLC, or professional LLP.

Close
Close corporations and similar entities are “closely held”. They owned by a small number of private parties such as family members.

B-Corporation
A Benefit Corporation (B-Corp) is basically a for-profit corporation dedicated to a nonprofit cause. This new type of corporation seeks to attain public benefit, environmental benefit, employee benefit, other social benefit; holds to standard in transparency of operations; and often obtains third-party certification.

Comparing Taxation Options

Partnership S-Corp Taxation C-Corp Taxation

Summary

The business does not pay corporate taxes; instead all profits, losses, deductions, and credits are reported on the owners’ tax returns and business tax is paid at the personal income tax rate. Like a pass-through entity, all profits, losses, deductions, and credits are reported on the owners’ tax returns and business tax is paid at the personal income tax rate. Owner-employees realize savings on self-employment taxes. S corporations are responsible for tax on certain built-in gains and passive income. C-Corporations suffer from double taxation: the corporation pays taxes on profits then shareholders pay taxes on their distributions. C-Corp taxation is appropriate when the benefits of deducting employee contributions and income splitting outweigh the costs of double taxation. Small businesses that will re-invest most of their profits in the business can benefit from the low tax rates on retained earnings.

Rule of Thumb

Best when <$75,000 profits per owner Best when $75,000-$250,000 profits per owner Best when $250,000+ profits per owner

Tax Forms and Rate

Businesses with more than one owner file an informational return of the allocation amongst owners (Form 1065).

Each owner reports his share of company profits, losses, deductions, and credits on his personal income tax return (often Schedule 1040 Schedule C). You will pay taxes for your portion of business earnings at your personal income tax rate.

Owner-employees are also responsible for self-employment taxes (15%).
S corporations are responsible for tax on certain built-in gains and passive income and must file Form 1120S.

Each owner reports his share of company profits, losses, deductions, and credits on his personal income tax return (often Schedule 1040 Schedule C). You will pay taxes for your portion of business earnings at your personal income tax rate.

Owner-employees only pay self-employment taxes (15%) on the “reasonable salary” they pay themselves.
C corporations pay taxes at corporate income tax rates. This is reported on Form 1120.

Each owner reports wages and distributions on his personal income tax return (often Schedule 1040). You will pay taxes only for wages and capital gains at your personal income tax rate. The distributions suffer from corporate double taxation since both you and the corporation are paying taxes on these earnings. Wages are deducted from corporate revenue prior to paying corporate income taxes (they do not suffer from double taxation).

The employer and employee each pay their share of employment taxes on wages.

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