Choosing your Business Structure – A How to Guide

When starting a business one of the most important initial decisions you’ll need to make is choosing the structure under which your business will operate. Your business structure can affect many things including how your business will be taxed and at what rate, how easy or difficult it will be to raise money, the paperwork you’ll need to file and how much you could potentially be personally liable for if you were to be sued. Given the importance of this choice, we’ve made this quick starter guide on choosing the best legal structure for your business.

Overview of Business Structures

• Sole Proprietorship
• Limited Liability Company (LLC)
• Corporation

Sole Proprietorship

sole proprietorship is the simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and you, the owner. You are entitled to all profits and are responsible for all your business’s debts, losses and liabilities.

Advantages of a Sole Proprietorship

• Easy and inexpensive to form: A sole proprietorship is the simplest and least expensive business structure to establish. Costs are minimal, with legal costs limited to obtaining the necessary licenses or permits.
• Complete control. Because you are the sole owner of the business, you have complete control over all decisions. You aren’t required to consult with anyone else when you need to make decisions or want to make changes.
• Easy tax preparation. Your business is not taxed separately, so it’s easy to fulfill the tax reporting requirements for a sole proprietorship. The tax rates are also the lowest of the business structures.

Disadvantages of a Sole Proprietorship

• Unlimited personal liability. Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions.
• Hard to raise money. Sole proprietors often face challenges when trying to raise money. You cannot sell stock in the business, which limits investor opportunity. Banks are also hesitant to lend to a sole proprietorship because of a perceived additional risk when it comes to repayment if the business fails.
• Heavy burden. The flipside of complete control is the burden and pressure it can impose. You alone are ultimately responsible for the successes and failures of your business.

Sole Proprietor Taxes

Because you and your business are one and the same, the business itself is not taxed separately-the sole proprietorship income is your income. You report income and/or losses and expenses with a Schedule CDownload Adobe Reader to read this link content and the standard Form 1040Download Adobe Reader to read this link content. The “bottom-line amount” from Schedule C transfers to your personal tax return. It’s your responsibility to withhold and pay all income taxes, including self-employmentDownload Adobe Reader to read this link content and estimated taxesDownload Adobe Reader to read this link content. You can find more information about sole proprietorship taxes and other forms at IRS.gov.

Forming a Sole Proprietorship

You do not have to take any formal action to form a sole proprietorship. As long as you are the only owner, this status automatically comes from your business activities. In fact, you may already own one without knowing it. If you are a freelance writer, for example, you are a sole proprietor.

But like all businesses, you need to obtain the necessary licenses and permits. Regulations vary by industry, state and locality. Use the Licensing & Permits tool to find a listing of federal, state and local permits, licenses and registrations you’ll need to run a business.

If you choose to operate under a name different than your own, you will most likely have to file a fictitious name (also known as an assumed name, trade name, or DBA name, short for “doing business as”). You must choose an original name; it cannot already be claimed by another business.

Limited Liability Company (LLC)

A limited liability company (LLC) is a business structure in the United States whereby the owners are not personally liable for the company’s debts or liabilities. Limited liability companies are hybrid entities that combine the characteristics of a corporation with those of a partnership or sole proprietorship. Due to the combined benefits of LLCs, they have become the the most preferred structure for in the U.S. Over 80% of small businesses are LLCs, and for many good reasons. With less requirements and more flexible ownership options than the other entities, LLCs provide business owners with limited liability protection. This means that the company assets are typically owned by the LLC and are separate from the personal assets from that of the LLC owner(s).

Advantages of a Limited Liability Company (LLC)

• Limited Liability Protection By forming an LLC, only the LLC is liable for the debts and liabilities incurred by the business — not the members. The members liability is limited to the personal interest they have invested in the company thus protecting the personal assets of the individual member that are separate from the LLC.
• Pass Through Taxation The LLC typically does not pay taxes for itself. Instead, the net income/loss is “passed through” to the personal income of the owner(s)/member(s), and is simply taxed as personal income. Federally, LLC taxation is handled very much the same as a partnership or sole proprietorship, in the case of a single member LLC.
• No Ownership Restrictions The LLC does not have any residency or citizenship restrictions, which allows foreign nationals to have ownership in an LLC, if desired. In addition, other corporate entities may be LLC members which means that other corporations or LLCs (or other entities) may be a member of the LLC, or may be the sole member (although an LLC with a sole member that is a corporation or LLC is treated for tax purposes as a partnership or multi-member LLC).
• Versatile Tax Status One of the most advantageous aspects of the LLC is that it has the ability to choose how it is treated as a taxable entity. According to the IRS an LLC is, by default, federally taxed as a partnership (in the case of a multi-member LLC) or as a sole proprietor (in the case of a single member LLC). The LLC, however, may elect to be taxed as a C- or S-corporation at any time the members so choose.
• Flexible Profit Distribution For an LLC, if the members choose, the net income/profits of the LLC may be allocated to the members in different proportions to their ownership percentage in the LLC. This is different from a corporation, as corporations are required to distribute profits exactly accordance with the proportion/percentage of ownership of each shareholder.
• Minimal Compliance Requirements LLCs are subject to limited state mandated annual filing requirements and ongoing formalities. While corporations are typically required to have at least an annual meeting of directors and shareholders (and initial meeting of the same), adopt bylaws, and keep minutes of all meetings and all formal corporate resolutions, an LLC is not required to do any of those things (see the explanation of an operating agreement, above). The LLC members may have whatever meetings they wish and may document any such things as they wish, however they are not required to do so.

Disadvantages of a Limited Liability Company (LLC)

• Self Employment Taxes Although we listed Pass Through Taxation as an LLC benefit, it can also be a disadvantage. Oftentimes the taxes that are passed through and reported as personal income of LLC members will be higher than the taxes at a corporate level. You will also still pay for federal inclusions such as Medicare and Social Security. If you’re confused if this business structure will be the right tax choice for you, it’s a good idea to speak to your accountant or financial advisor.
• Careful Personal Records As the owner of an LLC, you need to keep careful records of your business expenses — separate from your personal finances. This is the only way to ensure limited liability. Therefore, you should have separate bank accounts and cards to track business expenses.
• LLC Termination Usually, if a member departs an LLC, then the LLC is terminated and ceases to exist. This is unlike a corporation where it still exists regardless of what shareholders come and go.
• Banking Since it’s required to keep your business finances separate from your personal finances, you’ll need a business checking account. Banks usually charge a number of different fees and monthly expenses for these types of accounts. Also, If a check is made out to your LLC, then it is required to be deposited into a business bank account and cannot just be cashed. And some banks might charge extra for this type of deposit.

Limited Liability Company (LLC) Taxes

Unless the LLC decides to be taxed as a corporation, the LLC is considered a pass-through business. That is, the taxes of the business are passed through to the owners (members), to be included on the individual income tax return. The percentage of net income for the LLC is divided among the members according to their share, as determined by the operating agreement.

Single Member LLC Taxation

A single member LLC is taxed as a sole proprietorship. That is, the information about the LLC’s income and expenses, and its net income is prepared using Schedule C. The net income from the Schedule C is brought over to Line 12 of the owner’s personal tax return (Form 1040 or other).

Multi-Member LLC Taxation

An LLC which has more than one member typically pays income tax as a partnership. The partnership itself does not pay taxes directly to the IRS; the individual partners pay tax based on their share of ownership in the partnership.

The partnership files an information return with the IRS on Form 1065. Then a Schedule K-1 is prepared for each partner, showing the share of the profit/loss of the partnership. The K-1 is filed with the partner’s individual return and the gain/loss is shown on the partner’s Form 1040.

Forming a Limited Liability Company (LLC)

The formation of an LLC involves the filing of legal formation paperwork with the Secretary of State Office, known as Articles of Organization, Certificate of Formation OR Certificate of Organization. In addition to the filing of legal formation paperwork, the creation of an Operating Agreement is highly recommended. An Operating Agreement is a legal document that outlines the ownership and membership duties of the business.

Corporations

A Corporation is a form of business operation that declares the business as a separate, legal entity guided by a group of officers known as the board of directors. In general, a corporation has all the legal rights of an individual, except for the right to vote and certain other limitations. Corporations are given the right to exist by the state that issues their charter. While its exact legal status varies somewhat from jurisdiction to jurisdiction, a corporation’s most important aspect is limited liability. This means that shareholders may take part in the profits through dividends and stock appreciation but are not personally liable for the company’s debts.

Advantages of Corporations

• Owners have limited liability. The owners’ assets are protected from the debts and liabilities of the corporation. Shareholders are not held liable for business losses.
• Easier to raise capital. It is easier to attract capital with the sale of stocks and bonds. A corporation can have an unlimited number of investors.
• Easy to transfer ownership. Shares of stock can be sold.
• Corporations have perpetual lifetimes. The entity continues to exist beyond the deaths of the owners.
• Certain expenses are tax deductible. Owners can receive tax-free benefits such as deductions for retirement plans and insurance.

Disadvantages of Corporations

• Double taxation of corporation profits. The corporation pays federal and state taxes on its profits. When dividends are paid to shareholders, they are treated as income and taxed again. As a result for every dollar of profit generated by a Corporation, the total amount of tax paid is higher than any of the previously mentioned legal structures.
• States have higher fees. States charge annual franchise fees for corporations.
• More state and federal regulations and oversight. Tax filings are more complicated for corporations. States require the filing of Articles of Incorporation, corporate bylaws and annual reports. Corporations must designate a board of directors and hold annual meetings.

Corporation Taxation

Because a corporation is a separate legal entity from its owners, the company itself is taxed on all profits that it cannot deduct as business expenses. Generally, taxable profits consist of money kept in the company to cover expenses or expansion (called “retained earnings”) and profits that are distributed to the owners (shareholders) as dividends.

Corporate Tax Payments

The corporation must file a corporate tax return, IRS Form 1120, and pay taxes at a corporate income tax rate on any profits. If a corporation will owe taxes, it must estimate the amount of tax due for the year and make quarterly payments to the IRS by the 15th day of the 4th, 6th, 9th, and 12th months of the tax year. If a corporation uses the calendar year as its tax year, the payments are due April 15, June 15, September 15, and December 15.

Shareholder Tax Payments

If the corporation’s owners work for the corporation, they pay individual income taxes on their salaries and bonuses like regular employees of any company. Salaries and bonuses are deductible business expenses, so the corporation does not pay taxes on them.

Tax on Dividends

If a corporation distributes dividends to the owners, they must report and pay personal income tax on these amounts. And because dividends, unlike salaries and bonuses, are not tax-deductible, the corporation must also pay taxes on them. This means that dividends are taxed twice — once to the corporation and again to the shareholders. Smaller corporations rarely face this problem: Because their owners typically work for the corporation as employees, the corporation can pay them in the form of tax-deductible salaries and bonuses, rather than taxable dividends.

Forming a Corporation

Corporations are formed by filing legal paperwork with the Secretary of State known as Articles of Incorporation or Certificate of Incorporation, depending on your state. In this filing the name of the Corporation, which must be unique from any other existing Corporation is defined along with the appointment of the initial directors of the Corporation. In addition to the filing of Articles of Incorporation, Corporate Bylaws should be created. A Corporate Bylaws document outlines the rules that govern the day-to-day operations of the Corporation, such as when and where the directors’ and shareholders’ meetings will occur and what the directors’ and shareholders’ voting requirements are.