Maybe you came up with a business idea in the shower this morning, or maybe you’ve been nurturing a concept for years. Either way, starting a business is a big decision—and picking a business entity type is the first big step.
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The good news? About 600,000 new businesses open their doors each year, so you’re not traveling alone on this road. In fact, it’s more of a highway, and this is your map.
When push comes to shove, there is no “right” way to set things up. Choosing a business entity—also known as a business structure—that fits really depends on how many owners are involved, how big your dreams are, and how you want to pay both yourself and Uncle Sam.
Read on for the high-level lowdown on selecting the right business entity. If you have questions about the nitty gritty, it’s a really good idea to talk to a tax or legal pro.
Why is business structure important?
Not all business structures are created equal. In fact, each structure has definitive advantages and disadvantages. Some questions to ask yourself right off the bat are:
- How liquid do I want or need ownership of my business to be?
- How important is it to protect myself from personal liability?
- Which business entity will give me the best tax treatment?
- Which is the best business structure for attracting and retaining employees?
Different business structures can require more work to stay compliant, too, so you definitely want to make an informed decision. A good way to make sure you’re 100% informed is by pinging your friendly neighborhood accountant.
What types of business entities are there?
Drumroll, please. The main types of business structures are:
Admit it. You knew most of those already. But did you know that you’re already a sole proprietorship if you want to be one? Congrats!
Here’s an overview of each business structure to help you understand the differences and put you one step closer to choosing the way you want to run things.
A sole proprietorship is the easiest and least expensive way to start a business. If you’re already in business for yourself and haven’t actively chosen a different business structure, then you are a member of the esteemed sole proprietorship club.
While it is easy to get set up as a sole proprietor, make sure you understand the benefits and risks before you ride off into the small business sunset.
What is a sole proprietorship?
Being a sole proprietor literally means you own a business by yourself (and that it’s not structured as any other entity). Bottom line? You are your business.
If you choose a sole proprietorship, you have complete control over your business, including the timing and the amount of cash withdrawals you take out if it.
But with great power comes great responsibility. There is no legal distinction between you and the business, which means that you are personally liable for all debts, liabilities, and legal actions taken against the business.
Sole proprietorship pros and cons
|Easy and inexpensive to set up||Personal liability for all business debts and liabilities|
|Total control of the business||Self-employment tax|
|Cash withdrawal flexibility|
Your business is not taxed separately, so you pay personal income tax on the profits of the business. And in addition to income tax, you’ll also have to pay self-employment taxes, to cover things like Medicare and Social Security.
What does it take to set up a sole proprietorship?
If you operate under your own name, you don’t necessarily need to take any formal action to be considered a sole proprietorship.
There are a few exceptions:
- If you have employees: You’ll need an employer ID number (EIN) from the IRS.
- Special licenses: For any type of business entity, there may be things like city business licenses and fees to take care of. Also, some types of businesses (like ones that sell alcohol) need to obtain the proper business licenses and/or permits.
- If you operate under a different name: Sometimes it sounds better to use a name other than your own. If you want a distinct nom de business, you’ll also have to jump through a few relatively easy hoops to register a Fictitious Name, which is also called a DBA (Doing Business As) name.
If you think that owning and running a business is more of a team sport, then check out the partnership option.
What is a partnership?
Partnerships are literally defined as a relationship between two or more people who join forces to carry on a trade or business as co-owners. Centuries of literature and decades of pop songs proved that relationships can be wonderful, but they can also drive you nuts—that’s why the “structure” part of the “business structure” can really be your friend here.
If you choose a partnership, you and your partners will share in the profits and losses of the business, as determined by a formal partnership agreement that you all set up and sign. The partnership agreement also outlines many other important aspects of your business relationship, like how you’ll dissolve it, when you can take money out of the business, and how to resolve disputes. Take your time to set it up right!
Note that offering an employee the possibility of a partnership can also be a great hiring advantage. So use it wisely.
Partnership pros and cons
|Pooled resources and skills||Personal and joint liability|
|Competitive advantage in hiring because of partnership opportunities||Potential conflicts between partners|
|A clearly defined relationship between owners||Hard to divide up or sell pieces of the business|
If a partnership sounds good to you, you can can dig deeper by exploring the different types of partnerships, some of which can also offer some protection against liability.
What does it take to set it up a partnership?
The requirements for setting up a partnership are pretty similar to sole proprietorships. The only differences are that you’ll need an EIN for sure, whether you have employees or not.
And like we’ve said, it’s not required, but it’s a really, really smart idea to put together a thoughtful partnership agreement.
Now, let’s get this party started.
Sole proprietorships and partnerships have it all covered, right? Work by yourself or work with your friends! So why do some business owners invite in half the alphabet by structuring themselves as LLCs, S corps, and C corps? Three big reasons: avoiding liability, making it easier to have many owners, and the potential for tax savings.
On the liability end, the business structures we’ve talked about so far simply don’t protect you from all the bad stuff that can happen. What if you borrow money the business can’t repay, or if there’s a big accident? What happens if the business climate changes and things simply don’t work out? Or if a partner heads off to Aruba with all your cash? You are personally on the hook if you’re in a sole proprietorship or a partnership. Debtors can come after your savings, your house, and any of the other things you’ve worked so hard to build.
Protecting yourself from personal liability is just one reason, though. If you’re a partnership, how do you deal with having 20 partners (or 50 or 100)? What if one person wants to sell their share?
LLCs and corporations are designed to help you handle these kinds of issues.
Limited Liability Company (LLC)
First, let’s go over the option that doesn’t require incorporation: the LLC.
What is a limited liability company?
If having liability protection is important to you, then choosing an LLC is the most flexible way to structure your business.
An LLC is a hybrid structure that’s sort of halfway between a partnership and a corporation. This structure offers limited personal liability but gives more freedom than a corporation with regards to governance and choosing the most favorable tax treatment. LLCs are taxed as a sole proprietorship or a partnership, unless the owners (called members) elect to be taxed as an S or C corporation.
An LLC can be owned by an individual or by multiple members.
LLC pros and cons
|Limited liability||You need to be sure you’ve set it up right to take advantage of the best tax treatment|
|Easier and more flexible: you can be taxed like a partnership or a corporation without so many formalities||More formalities than a partnership or sole proprietorship|
What does it take to set it up a limited liability company?
You down with LLC? Yeah you know me!
Sorry. We couldn’t resist. Setting up an LLC has a few extra steps and fees than a partnership. If you are, in fact, down with LLC, you’ll need to:
- File Articles of Organization with the state. It’s just a simple form with some basic facts about the company. The cost varies by state.
- Announce your business. No, not just to your friends on Facebook. Some states, including New York and Arizona, require a you announce your LLC formation by publishing an ad in your local newspaper. Yes, there’s still a newspaper in your town, we promise.
- Create an Operating Agreement. Most states do not actually require you to set up an Operating Agreement. But for an LLC with multiple members, it is highly recommended to make sure everyone has the same expectations about things like selling shares, roles, and responsibilities.
If you want to avoid personal liability and have multiple owners (who are called shareholders with corporations), you may want to think about forming an S corp.
What is a S corporation?
An S corp is a business structure that behaves like a traditional C corporation (see the next section), but has a few important differences to make it easier run:
- Size: It must have fewer than 100 shareholders (all U.S. citizens or resident aliens).
- Taxation: In an S corp, the business itself is not taxed. Rather shareholders pay income tax on the profits and losses that pass through to shareholders’ personal tax return.
- Owner’s draw: When shareholders take money out of the business as a distribution, that money is not subject to payroll taxes. But, and this is important, the IRS insists that shareholders who are also employed by the corp must pay themselves a reasonable salary before they take a distribution. The IRS offers some guidelines but it is a huge gray area. This is a good one to talk over with your friendly neighborhood accountant.
S corporation pros and cons
|No corporate income tax||More complicated operations, processes, and governance rules|
|No payroll tax on an owner’s distribution||If you want to take a distribution, you must first pay yourself a reasonable salary and associated payroll taxes|
What does it take to set it up a S corporation?
Here’s the rub. There’s a lot more to do to set up and keep S corps in the good graces of the IRS and your state’s Secretary of State:
- You must file Articles of Incorporation (typically a simple form) through a state’s Secretary of State, and then elect to become an S corporation with Form 2553.
- You have to pay a filing fee and register with the IRS, plus state and local tax agencies.
- There are ongoing corporate compliance requirements to keep specific records and have regular director and shareholder meetings.
The big guys (and little guys who plan to get big) usually choose to structure themselves as C corps.
What is a C corporation?
C corps can have an unlimited number of shareholders, and it’s easier to set them up so that shareholders can buy and sell shares. In fact, most publicly-traded companies are C corps.
It’s also a business structure that’s popular among entrepreneurs and tech companies who plan to raise money, grow fast, and do things like offer employees a piece of the ownership pie.
Sounds great, right? Here’s the catch: The privilege of making ownership more liquid is balanced by the responsibility of doing more to create transparency for your shareholders and the state. That means more detailed recordkeeping and reporting.
C corps also get treated very differently when it comes to taxation.
C corps are subject to the corporate income tax. When shareholders receive income or dividends from a C corp, they’re taxed personally as well. This double taxation is a big drawback for many business owners, but it’s best to talk things through with a tax pro or attorney to make sure you really understand the nuances.
C corporation pros and cons
|Limited liability protection||Double taxation|
|Can sell shares to raise money||Complicated to maintain|
|Can offer shares to attract talent||Expensive fees and taxes|
What does it take to set it up a C corporation?
Just like forming an S corp, the major first steps include filing articles of incorporation, and registering with the IRS, state, and local agencies. After that, you’ll need to:
- Appoint directors and hold your first directors’ meeting
- Draw up bylaws
- Issue stock certificates to initial shareholders
Remember that there are also ongoing legal formalities when you run a C corp. It’s worth the expense and effort if you have your sights set high, but most small businesses prefer the tax advantages of other business structures to the benefit of having many shareholders.
Piercing the corporate veil
Now that we’ve run through all the business structures, there are a few more things you should know before you begin your journey. While some entity types protect owners from liability, they only do so if owners and their businesses truly exist independently.
Businesses need to be registered and they need to follow all the formalities outlined by their state. They also need to be financially independent and exist for legitimate (as opposed to fraudulent) reasons. If formalities aren’t followed, or if owners mix their personal and business finances, courts will “pierce the corporate veil” by making owners personally liable for the business’s debts.
So if you plan to organize yourself as an LLC or corp, be sure to follow all the requirements. Your attorney or accountant can help you get it right.
Pro tip: check out this small business taxes rundown for a comparison of the taxes for each business entity type.
So what’s your business structure?
Your business is unique. and what’s right for you might not be right for your neighbor’s business. So weigh your options, seek out good counsel, and then choose the business entity type that fits you best.
Good luck getting started — we hope to see you on the stock exchange some day (or just with an “open” sign down the street).