Small business formations—explained
Starting a small business is an endeavor that requires intentional thought and decision-making. One of the first important decisions you need to make concerns choosing the right business structure. The structure you select influences many things about your business, from the amount you pay in taxes to your everyday operations. And each one comes with its own set of benefits and challenges.
In this blog, we’ll break down the five common types of business entities and the pros and cons of each.
Sole proprietorships
If you’re looking for a business type that’s easy to form and grants you complete control over your business (i.e., the only person in charge), a sole proprietorship is the way to go. You’re automatically considered a sole proprietorship if you perform business activities but don’t register as any other business. Note: Sole proprietors must report earnings on schedule C of their personal returns.
Pros:
The least expensive—and easiest—to establish.
As the owner, you keep all profits.
The tax process is simplified because income is reported on personal tax returns.
Cons:
Business assets and liabilities aren’t separate from personal assets and liabilities.
It’s harder to secure business loans or investors.
Upon death, your sole proprietorship will typically cease operations, and assets become part of your estate.
Partnerships
When owning a business with one or more people, a partnership is the simplest structure to select. There are two common types of partnerships:
Limited partnerships (LP) have one general partner with unlimited liability (i.e., personally responsible for any loss of the business), while all other partners have limited liability (i.e., liability for debts is restricted to the amount they put into the business).
Limited liability partnerships (LLP) give limited liability to every owner and protect each partner from debts against the partnership.
Pros:
Partners bring different skill sets and knowledge to the partnership.
There is less financial burden for all involved.
Taxes pass through to the business owners on individual tax returns.
Cons:
Partners are personally liable for business debts.
All profits are shared between partners.
There’s potential for disagreements and partnership disputes.
C corporations
When you form a C corporation (C corp), you’re creating a legal structure where owners or shareholders are taxed separately from the entity. They’re also subject to corporate income taxation, which means business profits are taxed at both the corporate and personal levels (i.e., double taxation).
Pros:
Personal liability of directors, shareholders, employees and officers is limited; legal obligations can’t become a personal debt obligation of any individual.
C corps can offer shares of stock, which may fund new projects and/or future expansions. Note: When C corps reach $10 million in assets and 500 shareholders, they must register with the Securities and Exchange Commission (SEC).
The business has an unlimited lifespan as owners can change, and management can be replaced.
Cons:
Filing articles of incorporation can be costly and incur greater legal fees.
Profits are taxed twice—when the business files its income taxes and when profits are distributed as dividends.
Shareholders cannot deduct business losses on tax returns.
S corporations
Unlike C corps, S corporations (S corps) pass their taxable income, credit, deductions and losses directly to their shareholders, known as a “pass-through” entity. S corps are available only to small businesses with 100 or fewer shareholders.
Pros:
There are no corporate taxes so there is no double taxation like a C corp.
Personal assets are protected, as shareholders are not personally responsible for business debts and liabilities.
Ownership can be transferred without adverse tax consequences.
Cons:
There are restrictions, such as limiting S corps to one class of stock, no more than 100 shareholders and foreign ownership is prohibited.
Because amounts distributed to a shareholder can be dividends or salary, the IRS may scrutinize payments more closely.
There is less flexibility in allocating income and loss because they’re governed by stock ownership.
Limited liability company
Like an S corp, limited liability companies (LLCs) are also “pass-through” entities where business income is part of the owner’s income without a separate tax (i.e., limited liability protection). Owners are typically referred to as “members.”
Pros:
Members have no liability for acts of the LLC or its other members, meaning personal assets are not at risk in relation to business debt.
There is flexibility in membership, so members can be individuals, trusts, partnerships or corporations, and there is no limit on the number of members.
Members can manage the LLC or elect a management group to do so.
Cons:
LLCs can have higher startup and maintenance costs, as many states impose ongoing fees like annual reports and/or franchise tax fees.
It’s harder to transfer ownership for an LLC, as all members must approve adding new members or alternate ownership percentages of existing members.
Because members are considered self-employed, they must pay the self-employed tax contributions toward Medicare and Social Security.
Work with a professional
Selecting the best business structure is a decision that can’t be taken lightly—it impacts your taxes, liability and the ability to grow your company. Think about the risk you’re willing to take and where you want your business to go. Be sure to consult with financial and legal professionals for insight into the business formation that’s right for you. Doing this will help position your business for success.