Starting a new business is a thrilling time. As exciting and fun as it is, however, it can also be tremendously difficult and challenging. In order to give yourself the best chance at long-term success, you have to think through every possible outcome for every facet of your business. One of these particular challenges in the early phases is determining the best legal structure for your business. Not only is there a variety of entity types to choose from, but each one possesses its own rules, tax treatment, and filing requirements. The truth is, there’s no one-size-fits-all. Rather, it’s a matter of comparing each option side-by-side to determine which structure gives your business the most advantages as they pertain to your long-term needs and goals. In this article, I’ll explain the differences between each entity type and cover some of the important considerations you need to take into account in your decision with the hopes of helping you determine the best legal structure for your own small business.
The Different Entity Types
This is the simplest, most straightforward legal structure you could choose for your business. A sole proprietorship is NOT considered a separate legal entity. Rather, “it simply refers to a person who owns the business and is personally responsible for its debts,” according to Entrepreneur.com. This means if your business runs into financial trouble, creditors can bring lawsuits against you and your personal assets. In other words, no corporate veil exists as protection.
All you need to do to set up a sole proprietorship is to register your trade name and secure any required local licenses. Just as there’s no entity separation between business and owner, the same goes for taxation. All profits and losses are reported on the sole proprietor’s personal income tax return. This means all sole proprietor income qualifies for the new qualified business income deduction of up to 20%, and filing taxes simply requires a Schedule C (profits and losses) and Schedule SE (self-employment tax) to be filed along with the personal tax return (Form 1040).
Partnerships require at least two or more individuals and include two different types: general partnerships and limited partnerships.
General partnerships are formed under the pretense that all partners agree to share in all profits and losses and all financial and legal obligations of the business. General partners possess “agency powers,” meaning “any partner can enter into a binding agreement, contract or business deal that all partners are obliged to adhere to,” according to Investopedia. Also, all partners possess unlimited liability, meaning their personal assets are liable to the partnership’s obligations and any partner can be sued for the entirety of the business’s debts or assets.
In limited partnerships, at least one of the partners is considered a general partner and is responsible for the day-to-day operations of the business. This general partner is treated the same as a general partner in a general partnership as described above. The remaining partners are considered limited, or silent, partners, and they contribute capital but do not make any managerial decisions. As a result, they also benefit from limited liability, meaning they are only liable for the business’s debts up to the amount of capital that they contributed. Profits and losses flow through to partners’ personal tax returns as specified by the terms of the partnership.
Neither type of partnership provides full protection (unlike other entities) of partners’ personal assets from the business’s creditors. Both types of partnerships typically require very little paperwork or registration fees to be paid to set up.
Limited Liability Company (LLC)
LLC’s provide the most flexibility of all the different entity types in terms of how they are structured and the level of legal protection they provide. LLC’s can be set up as either a Single-Member LLC, a Partnership LLC, or a Corporation LLC. All provide at least some degree of protection from personal liability for the business’s debts.
Single-Member LLC’s consist of, as the name implies, only one member. If Single-Member LLC’s do not elect to be taxed as a corporation, they are considered by the IRS to be “disregarded entities”, meaning they’re disregarded as a separate entity from the owner (read more at IRS.gov). As a result, they are treated like sole proprietorships in that all profits and losses of the business flow directly to the owner’s personal tax return but with the added benefit of personal liability protection from the business’s debts. It’s important to note, however, that Single-Member LLC’s do not offer as robust of personal liability protection as the other LLC structures do. This is due to their “disregarded entity” status which allows a court to overturn the liability protection it otherwise offers. Single-Member LLC taxes are done just like sole proprietorships are.
Partnership LLC’s consist of at least two or more partners. Profits and losses flow through to partners’ personal tax returns according to their specified ownership percentage (equity) in the company. This type of LLC offers full personal liability protection to all partners, both from the business’s debts and any wrongdoing from other partners or employees of the business. Partnership LLC taxes require filing a Form 1065, U.S. Return of Partnership Income. That information then flows onto a Schedule K-1, which shows a partner’s share of income, deductions, credits, etc. Each partner then uses their Schedule K-1 for their personal tax return (1040) and pay self-employment tax on their individual share of partnership earnings. Partners are subject to self-employment tax and federal/state income tax.
Corporation LLC’s have the option to choose from two different corporation taxation structures as either a C Corporation or an S Corporation. Normal corporate tax rules apply to both, which we’ll cover in the corporation’s section below.
A corporation is considered a completely separate entity from its owners. This means the corporation itself has its own legal rights aside from the owners. These rights include the ability to sue, be sued, own/sell property, and sell ownership in the corporation in the form of stock. There are five main types of corporations:
- C Corporations: these are owned by the shareholders and are taxed independently of each other (also called “double taxation”). Shareholders can be managing partners, employees, or simply investors. Profits can be disbursed to the shareholders in the form of dividends which, under the new tax laws, are capped at 15% for most individual taxpayers. Owners are also capable of receiving compensation for services rendered in their capacity as an employee, which is considered w-2 income (see S Corporation explanation below).
- S Corporations: these are structured more like partnerships or LLC’s in that they are owned and operated by the owners or partners only and provide limited liability protection. Single-Member and Partnership LLC’s can elect to be taxed as an S Corporation. S Corporations require the business to pay its owners (aka employees) “reasonable compensation” in the form of a w-2 salary. Since this is w-2 income, it is subject to payroll taxes and ordinary income tax. In addition to their w-2 income, owners can also take “owner distributions” from the business profits. These distributions qualify for the qualified business income deduction and are only subject to ordinary income tax (as opposed to self-employment tax as well).
- B Corporations: these are also known as benefit corporations and are more a certificate or designation than particular tax structure. Benefit corporations are for-profit businesses but they are structured to do good for society. The famed outdoor gear label, Patagonia, for example, is a certified B Corporation because of their focus on being environmentally friendly as well as their financial support of other environmental charities. Aside from their charitable contributions, B Corporations are otherwise taxed as a C or S Corp.
- Closed corporations: these are “generally..smaller corporation[s] that [elect] close corporation status and [are] therefore entitled to operate without the strict formalities normally required in the operation of standard corporations,” according to Entrepreneur.com. They’re basically corporations whose shareholders and directors can choose to operate like a partnership and they can elect to be taxed as either a C or S Corp.
- Nonprofit corporations: everyone is familiar with nonprofit corporations. They are as the name implies – not for profit. They are designed to help others in some way and are NOT taxed at all as a result.
Cooperatives are simply private companies that are owned and controlled by the customers who shop their products, supplies, or services. They can vary in type and membership size, but they’re all designed to meet the specific objectives of its members. You’ll often find cooperatives amongst local grocery stores. Here in Seattle, for example, we have the largest consumer-owned food cooperative in the United States called PCC Community Markets. It has over 58,000 members, operates twelve retail locations, and does over $277.6 million in revenue per year. Their focus is to support local, organic farmers, invest back into the community, advocate for quality food, and protect generations of farmland. As a result, their food is only locally sourced organic products. It cost a one-time, fully-refundable fee of $60 plus a nonrefundable processing fee of $2 to join.
Important Considerations in Choosing Your Legal Structure
Picking the right legal structure from the get-go is extremely important as it can be quite difficult to change once you’ve already registered your business. You’ll need to think both short-term needs and concerns as well as long-term growth and big-picture vision. Below, I cover the most important of these.
If you are bootstrapping your business with practically nothing, you don’t want to make setting up your legal entity difficult, costly, or time-consuming. With sole proprietorships, partnerships, and LLC’s being the easiest, quickest, and least expensive to create, it would make more sense to choose one of these over a corporation.
Do you have a lot of personal assets potentially at stake? Are you going into a high-risk industry, such as financial services or manufacturing, that could easily open the door to getting sued even if you did nothing wrong? You need to consider what level of personal asset protection you need before you open your doors.
Where do you see your business going in 5 years? 10 years? 15 years? Will you be hiring employees or bringing in new partners? If you want to incentivize your employees, you might want to structure as a corporation so you can issue stock as additional compensation. If you want to bring in new equity partners, you might want to structure as an LLC.
Corporations require double taxation, meaning the business pays taxes and the owner pays taxes. This can be difficult to manage in the early years of a business before you’re even profitable. LLC’s provide pass-through income, so you can avoid this double taxation. They also provide the ability now to deduct up to 20% of their income from taxation at all. Understanding what makes sense from a tax perspective will dictate much of your choice in legal structure.
With sole proprietorships or LLC’s, you’re the owner AND operator of the business. You’re in complete control of what happens on a day-to-day in your company and the direction it heads in. In corporations, they’re required to have a board of directors that make the major decisions that guide the company’s direction. It’s possible that the owner is that board of directors in the early stages, but as it grows, it needs to operate the business more as a board-directed entity. Knowing what level of control you desire long-term will help you decide which legal structure makes the most sense.
If you plan or need to bring investors on board at some point, you’d likely want to structure your business as a corporation from the get-go so you can more easily issue ownership stakes in your company to those investors in the form of stock. LLC’s, on the other hand, may be required to use their own personal credit or assets to secure outside investments.
Depending on what industry you are in or where your business is located, you may require additional licenses or permits to operate. These may also be followed by additional regulations and additional steps you may have to take as a result.
Hopefully, you have a better understanding now of the options available to you. If you have additional questions or questions specific to your own situation, please don’t hesitate to reach out or schedule a free consultation with me.
Disclaimer: Millennial Wealth, LLC does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
Chad Rixse grew up in Anchorage, Alaska, but has lived in the Seattle area since 2007. He majored in Spanish at the University of Washington where he honed his fluency in the language and discovered his passion for travel and connecting with other cultures. He’s a self-professed golf addict who can never seem to get his fill despite still struggling to break 100.