The business structure you choose when setting up the business affects it in a variety of ways. It can determine day-to-day operations, the way you’re taxed and your personal liability for the business’s debts and mistakes. You must make the right choice up front because it is costly and time-consuming to change at a later point, not to mention all the potentially costly consequences of legal action. Here is an overview on how to choose the right legal structure for your business.
A sole proprietorship has simplicity in its favor. You are automatically considered a sole proprietorship once you start doing business as an individual. You don’t have to register anything. You don’t even have to get a separate tax ID number. At tax time, all income and expenses are filed on a Schedule C 1040 form.
A partnership is the simplest way to set up a business with two or more owners. Partnerships should be based on a legal document and not a handshake deal.
Limited liability companies require some effort to set up, but they come with a number of benefits; you can reserve a business name, you can transition a partnership to an LLC rather easily, and if you set up an LLC, you could convert to an S corporation later.
Corporations are more difficult to set up at the beginning, and you then have to continue filing paperwork on behalf of the corporation. However, the corporation is a separate legal entity from those who founded it. It could, in theory, last well beyond your lifetime. You can more easily sell it or take it public than other types of business. Conversely, corporate boards can end up determined by shareholders and occasionally eject the founder from the board. Then the business’s founder no longer has any decision-making authority.
Taxes and Tax Planning
Taxes are one of the main disadvantages of sole proprietorships. You typically have to pay self-employment taxes on top of personal income taxes. Once you have partners, you’ll have to file a partnership tax return. The business’s profits typically flow to the partners based on their partnership agreement; each partner then has to pay taxes on their income from the business.
The main benefit of an LLC is that it gives you significant flexibility in how businesses are set up and run. Depending on your jurisdiction, you could use corporate tax rules or partnership rules. In the case of a partnership, the profits pass on to the partners who are subject to pass-through taxation. You’ll have to file an annual tax return discussing the income each partner received, and partners report their share of income on their personal tax returns. In a limited partnership, the partners without limited liability have to pay self-employment taxes in addition to income taxes.
An LLC doesn’t save you on taxes in any way. When you set up an LLC and revenue passes through it to the owner, that person pays taxes on it as if they’re a self-employed sole proprietor and the business has an ordinary net income. One downside is higher filing fees for the LLC.
An S corporation has one major benefit for shareholders and partners – it eliminates self-employment taxes. You don’t owe Social Security and Medicare taxes on your share of an S corporation’s income.
Personal Legal Liability
One problem with a sole proprietorship is that it doesn’t protect your personal assets and liabilities from those of your business. If your business is sued, you could lose your personal savings and home. You can start a sole proprietorship while testing your idea before moving on to an LLC or other type of business. What is an LLC? It stands for limited liability company. If you want to learn more about what is an LLC, read this post for more information. One of the biggest benefits of an LLC is that it protects your personal assets from lawsuits against the business. This is essential if you’re working in construction or consulting and thus at significant risk of being sued.
Limited liability is available with other business structures. For example, in a limited liability partnership, they give limited liability to every partner. The LLP protects partners from debts and lawsuits against other partners. Now you aren’t liable if they’re sued for medical malpractice or go bankrupt. You can set up a partnership before upgrading to a more formal business like a corporation.
S corporations provide the same asset protection as LLCs. This personal asset protection comes in addition to the elimination of the self-employment tax. Conversely, the company’s income is taxed twice. The corporation pays taxes on it. Then the stockholders and owners pay taxes on the dividends they receive.
In a sole proprietorship, you’re making all the decisions because it is your business. If you hire help, they’re either employees or contractors you hire for a particular project. You’re still in charge.
Partnerships may give partners equal say in the business, but they may not. There are two main types of partnerships; limited partnerships and limited liability partnerships. In a limited partnership, one partner has all the liability while the others have limited liability. However, the limited partners also have limited decision-making.
An LLC provides significant personal protection for both the business owner and manager. This explains why LLCs are regularly created to hold rental property. Then the property owner can’t be sued when someone is injured on the premises, and the property manager isn’t personally liable, either, for the decisions they make as part of their job.
One advantage of corporations is that they havethe ability to raise funds by selling stock. The downside is that these stockholders may get a say in the running of the company.
Take factors like the ownership rules, legal liability and filing requirements into account before you start your business. The right choice for you depends on the risks you’re taking, how many others are joining you, and your long-term vision.