One of the most important choices you will make when starting a business is what type of structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, it will affect the amount of paperwork your business is required to do, plus the personal liability you face and your ability to raise money.
When you are first starting out in business, it is not uncommon to be “caught up in the moment.” You are consumed with getting the business off the ground, but you must remember that one of your goals is to maximize the flexibility of the ownership structure by considering the unique needs of the business, as well as the personal needs of the owner or owners.
The type of business entity you choose will depend on three primary factors: liability, taxation, and record-keeping. Here is a quick look at the differences among the most common forms of business entities:
This is the simplest structure, which usually involves just one individual who owns and operates the enterprise. Your profits and losses are recorded on your personal income tax return. There are a few disadvantages to consider, however. You are personally liable for your company’s liabilities, which means you are putting your own assets at risk, and they could be seized to satisfy a business debt or legal claim filed against you. Furthermore, raising money can be difficult. Banks and other financing sources are reluctant to make business loans to sole proprietorships. In most cases you will have to depend on your own financing sources, such as savings, home equity, or family loans.
This involves two or more people who agree to share in the profits or losses of a business. A primary advantage is the tax treatment. A partnership does not bear the tax burden. Any profits or losses are “passed through” to partners to report on their individual income tax returns. A primary disadvantage is liability. Each partner is personally liable for the financial obligations and debts of the business, putting each partner’s personal assets at risk, just like a sole proprietorship.
Limited Liability Company (LLC)
Allows owners to take advantage of the benefits of both the corporation and partnership forms of business. The advantages of this business format are that profits and losses can be “passed through” to owners without taxation of the business itself, while owners are shielded from personal liability.
The corporation becomes an independent entity, separate from its owners, who handle the responsibilities of the organization. Like a person, the corporation can be taxed and can be held legally liable for its actions. The corporation can also make a profit. The key benefit of corporate status is the avoidance of personal liability; you are not putting your personal assets at risk. The primary disadvantage is the cost to form a corporation and the extensive record-keeping that is required. Also, owners of the corporation pay a double tax on the business’s earnings, so not only are you subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income returns.
The S-Corporation (a popular variation of the regular C-corporation) has some appealing tax benefits and still provides business owners with the liability protection of a corporation. An
S-Corporation allows income or losses to be “passed through” to shareholders to report on their individual tax returns. As a result, there is just one level of federal tax to pay.