Of all the decisions you need to make when starting a small business, one of the most crucial is the type of legal structure you choose for your company. The type of business structure you select not only impacts your tax treatment, but also the legal liability you may face. Throw in your ability to raise money and the amount of paperwork you need to complete, and you can see selecting a business structure isn’t something to take indifferently.
Here’s an overview of the common types of small business structures and the quick-and-dirty differences among them.
As the most common form of small business organization, a sole proprietorship is also the simplest. Although this structure allows for total managerial control to the small business owner, the owner is also personally liable for the financial obligations and debts of the entity. In a sole proprietorship, business income is reported on the owner’s 1040 tax form (Schedule C). The sole proprietorship is responsible for self employment tax, which consists of social security and medicare.
A partnership is a type of business structure where two or more people who make an agreement to share the businesses’ losses and profits. The profits and losses of the partnership are “passed through” to the partners, who report their share on their individual income tax returns. Similar to a sole proprietorship, each partner is personal liable for the debts and obligations of the partnership.
A corporation is one of the most typical types of small business structure, and is also a favorite organizational structure for startup companies looking for future venture capital investors or planning on going public. The corporation becomes a legal entity to conduct operations of a business, but is separate from the founders who started it. The corporation can be held legally responsible for its actions, and can be taxed. One of the key advantages of the corporation business structure is the avoidance of personal liability. However, a drawback of a corporation is the cost of formation, and the extensive recordkeeping. Some corporations (C corporation) can be subject to double taxation (corporation and shareholders are taxed), but an S corporation enables corporation income or losses to passed through to personal individual tax returns.
Limited Liability Corporation
Keeping to its namesake, the individual liability is limited under the limited liability corporation, or LLC. An LLC is a hybrid structure, which contains benefits of both a corporation and partnership. You can avoid the double taxation that occurs in C corporations by choosing to have LLC income passed through to the company’s members. Here, the members are subject to self-employment taxes, but the LLC pays not income tax. Further, LLCs can distribute profits anyway they choose, rather than having to distribute dividends in proportion to share held as in a S corporation. For the income allocation flexibility, a LLC offers more freedom than some other structures. LLC owners are also shielded from the legal liabilities of the entity.
What’s the bottom line? Don’t take the types of small business structure decision lightly. Vigilantly consider the specific goals and needs of the owners and business. Lastly, seek expert advice before resolving yourself on a particular business structure.