Americans are hungry to start businesses and have more tools than ever to tap into the United States’ free enterprise system. But starting a small business requires more than dreaming big, It requires choosing the appropriate business structure.
To achieve the American dream of being your own boss and running your own company, you must be pragmatic and idealistic. One of the first practical concerns you face as a business founder is how to structure your business legally.
Among the factors to consider when choosing an entity structure are the complexity of the business, the potential risks it faces, protecting your personal assets from claims against the business, and the amount you pay in taxes.
Choosing a structure is one of the first and most essential steps in starting a new business. A business’s structure, which you should select before registering your business, affects issues such as taxation, fundraising ability, filing requirements, and personal liability, so it is essential to choose wisely.
Each of the following business structures provides a different mix of benefits, drawbacks, and legal protections to business owners:
A sole proprietorship is a business founded and owned by a single individual. It is the least complicated type of business to set up and is the default structure for a business owned by one person not registered as another entity type.
Sole proprietors should register an assumed business name (i.e., a “Doing Business as” or DBA name), typically in the county where they are located. The Internal Revenue Service (IRS) does not require a sole proprietor to obtain a separate employer identification number (EIN) or taxpayer identification number (TIN); the business’s profits and losses are reported on the owner’s personal income tax returns.
Sole proprietors have complete control over the company’s operations and are responsible for its day-to-day management. They own all assets and keep all the business's profits. Still, because there is no legal distinction between them and the business, their personal liability is not limited. That means their car and house could be vulnerable to lawsuits against the business or claims made by its creditors.
Like sole proprietorships, partnerships are simple and inexpensive to organize. They can be established without a formal state filing or entity registration, provided the business is a general partnership, not a limited partnership (LP) or limited liability partnership (LLP). Those who choose an LP or LLP structure must register the business with the state. The type of partnership affects a partner’s liability for the actions and debts of other partners and how much control they have over day-to-day management.
General partnerships typically must register their DBA in the county where the business is located. Also, like sole proprietorships, income from a partnership is reported on each partner’s personal income tax returns; however, partnerships must also file an information return to report the partnership’s income, gains, losses, deductions, and credits from its operations.
Because partnerships involve two or more people, some complexities are not encountered with sole proprietorships. The partners should enter into a partnership agreement that states how the business will be operated and how any future disputes will be handled.
Entrepreneurs who want to test their business idea before creating a more formal business entity, such as a corporation, may use sole proprietorships and partnerships.
Filing articles of incorporation with the appropriate state agency creates a legal entity separate from the corporation’s owners, i.e., the corporation’s shareholders. Legally, corporations have many of the same rights and responsibilities as individuals. They can earn a profit, pay taxes, buy and sell assets, and sue and be sued. An essential benefit of forming a corporation is that a corporation’s shareholders typically cannot be held personally liable for the corporation’s debts and obligations.
Compared to other forms of businesses, corporations involve more complexities and costs, including higher formation costs, more extensive record-keeping and reporting requirements, and double taxation. A corporation that meets specific requirements may elect to be taxed as an S corporation to allow profits and losses to pass through to the shareholders, avoiding the double taxation of C corporations, which are taxed on profits and then again when shareholders receive dividend payments.
Limited liability companies (LLCs) are a hybrid business structure that combines the limited liability protection of corporations but allows profits and losses to be passed through to the owners’ (members’) personal income, similar to sole proprietorships and partnerships. Typically, an LLC’s members are not personally liable for the LLC’s debts and obligations.
Flexibility is one of the primary benefits of the LLC structure. LLCs must be registered with the state and file annual reports, but owners may create an LLC operating agreement that governs the rights and duties of each member.
IRS tax treatment of an LLC varies depending on whether the members have decided to be taxed as a partnership in the case of a multimember LLC or as a disregarded entity in the case of a single member LLC—the default classifications in the absence of another election—or have elected to be taxed as a C or S corporation. LLC owners are considered self-employed individuals unless a corporate tax structure is elected. They must pay self-employment tax (Social Security and Medicare taxes) on compensation they receive from the LLC.
When starting a new business, you must position it for success using a sound business strategy. Please book a Discovery Call for advice about choosing an entity structure and the other legal considerations involved.
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