You do not have a create a formal business structure if your operation is small and your liability risk is limited. If you sell custom cat pillows from home, for example, you don’t need to worry about business organizational structure.
Many of you will grow your business or take on risk in the market, however, so this article will help you with choosing a legal business structure (sometimes called a business type). We will examine the various types of business ownership and help you pick one that is suited for you and also explain the benefits of incorporated business structures.
Those of you that start small and grow at a modest pace will probably end up using one of these types of small business:
- Sole Proprietorship
- Limited Liability Company
- S Corporation
Other company structure types are better suited for large businesses. If you plan to start off with a big bang or know that you want to get huge, you’ll want to consider the benefits of a larger business structure:
Now let’s look at each business structure in more detail.
A sole proprietorship is the simplest business structure. It’s basically just you, the owner. You get all the money and have all the responsibility.
There aren’t any .You just start doing business and, voila!, you are a Sole Proprietor. Examples of this business structure: freelance designer, writer, consultant. You still need to get the correct license or permit, if your state or county requires one. You just don’t need fancy paperwork and a corporate seal to be legit.
Do you want to be Cat Customs instead of Sally Smith? No problem. Just file a DBA (doing business as) form with the state and your local bank. This will keep you from being arrested when you cash checks (so awkward).
Legally speaking, you and your business are the same thing. You will report income and loss using the Schedule C on the standard Form 1040. You have to withhold and pay all income taxes including self-employment taxes. Gotcha: You can’t wait until the end of the year to do this. The IRS expects you to make quarterly estimated tax payments based on your projected income (or last year’s numbers).
- Easy to start — Little paperwork and
- Total control — You get to make all the decisions
- Easy tax prep — Simpler forms and the lowest business tax rates
- Personal liability — It’s all you, baby. No corporate shield to hide behind.
- Limited fundraising — No stock to sell. Banks get nada if you fail, so loans are tough.
- Pressure — Success or failure is all about you. This is the other side total control.
A partnership is a single business where ownership is shared by — surprise! — two or more people. All partners contribute to the money, property, labor or skill of the business and they all share the profit or loss.
Making decisions with multiple owners can be a challenge, so discuss the big rocks up front. You may think that you are highly compatible already, but these early discussions of principles, core values, and methods will bring differences to light. Decide together how you will:
- Make decisions
- Divide profits
- Resolve conflict
- Handle ownership changes
- Dissolve the partnership
Put these principles down in your partnership agreement. You don’t have to make a legal agreement, but do it anyway. You take a huge risk operating without one. If your would-be partner doesn’t see the need, then think twice about going into business with them.
There are three general types of partnership arrangements:
- General Partnerships — Management duties, risk, and profits are assumed to be equal among partners. Anything different can be detailed in the partnership agreement.
- Limited Partnerships — allow limited liability for partners as well as limited management input. Attractive to investors of short-term projects.
- Joint Ventures — Limited time and for a single project. Partners can continue after the project but must file as a general partner.
Register your business in your state, usually through the Secretary of State.
You’ll also need to establish your business name. For partnerships, your legal name is the name given in your partnership agreement or the last names of the partners. If you choose to operate under a name different than the officially registered name, file a DBA.
Obtain the necessary business licenses and permits. Regulations vary by industry and geography.
Most businesses will need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit.
A partnership must file an “annual information return” to report the income, deductions, gains and losses from the business’s operations, but the business itself does not pay income tax. Instead, the business “passes through” any profits or losses to its partners. Partners include their respective share of the partnership’s income or loss on their personal tax returns.
Partnership taxes generally include:
- Annual Return of Income
- Employment Taxes
- Excise Taxes
Partners are responsible for several additional taxes, including:
- Income Tax
- Self-Employment Tax
- Estimated Tax
Partnerships must furnish copies of their Schedule K-1 (Form 1065) to all partners by the date Form 1065 is required to be filed, including extensions. Partners are not employees and do not get a Form W-2. See the IRS Guide to Partnerships.
- Inexpensive — Easily formed business structure with few startup expenses
- Shared Commitment — Each partner is equally invested. They can pool resources to obtain capital.
- Blended Strength — Benefit from the strengths, resources and expertise of all partners
- Performance Incentive — May offer employees the opportunity to become a partner, attracting highly motivated and qualified staff
- Personal Liability — Partners have shared among the owners for their own actions and also for the debts and decisions made by other partners.
- Conflict — Partners must learn to compromise and resolve disputes well.
- Shared Profits — Joint owners share the successes and profits of their business. Inequity in contribution of effort or resources can cause discord.
Limited Liability Company
A limited liability company (LLC) is a hybrid business structure that combines two others: It provides the limited liability features of a corporation plus the operational flexibility and tax benefits of a partnership.
In an LLC the owners are called members. Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs.
Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.
Business Name. States are picky about you set up your LLC business name:
- Must be different from every existing LLC in your state
- Must include “LLC” or “Limited Company”
- Must not include restricted words like “bank”
Articles of Organization. This simple makes your LLC legit and includes information like your business name, address, and the names of its members. Typically filed with the Secretary of State but this may vary from state to state. Expect a filing fee.
Operating Agreement. Recommended for multi-member LLCs but not always required. This document structures your finances and organization. It also lays out percentage of interests, allocation of profits and losses, and member’s rights.
Licenses and Permits. Obtain proper business licenses and permits. These vary by industry and geography.
Business Announcement. Some states require you to publish a business formation statement in your local newspaper.
An LLC is not a separate tax entity, so taxes are passed on to the members and paid through their personal income tax. While the federal government does not tax income on an LLC, some states do, so check your state rules.
How the IRS treats your LLC for tax purposes depends on the elections made when you set it up. Depending on your classification, you may file your taxes as a sole proprietor (Schedule C), a partnership (Form 1065), or a corporation (Form 1120). See the IRS.gov LLC explanation for details. Talk to your state tax agency about what classifications they will recognize for your LLC.
Limited Liability. Members are protected from the actions of the LLC such as massive debt or lawsuits. Members are not necessarily shielded from wrongful acts, including those of their employees.
Simpler Records. The ease of operation is a big plus. Less registration paperwork and smaller start-up costs.
Profit Sharing. LLC members distribute profits as they see fit. Each member can contribute different levels of money and effort, so the members decide as a group who has earned what percentage of the profits or losses.
Dissolution Events. If a member leaves, some states dissolve the LLC and the remaining members must shut down the business. Members can decide if they want to start a new LLC or part ways. You can protect against this automatic headache by adding provisions to your operating agreement to prolong the life of the LLC after a member leaves.
Self-Employed Taxes. Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security.
An S Corporation (or ‘S Corp’) is a corporation with the Subchapter S designation from the IRS. This legal entity is separate from the owners, which limits their financial liability. This protection does not necessarily shield you from all litigation such as an employee’s tort actions in a workplace incident.
Profits and losses pass through to your personal tax return, which eliminates tax on the business itself. To keep you from gaming the system, however, a shareholder who works for the company must pay him or herself a reasonable compensation. Otherwise, the IRS might reclassify any additional corporate earnings as wages. That will hurt!
Before you form an S Corporation, determine if your business will qualify under the IRS rules. Then you file as a corporation. After you are considered a corporation, all shareholders must sign and file Form 2553 to elect your corporation to become an S Corporation.
Next, obtain the proper business licenses and permits. Regulations vary by industry and geography.
You can request S Corp status for your LLC by asking for a special election from the IRS on Form 2553. This must be done early in the tax year in which the election is to take effect. If you get the S Corp election, your LLC remains a limited liability company but is taxed as an S corp.
All states do not tax S corps equally. Most follow the federal rules and tax the shareholders accordingly. However, some states tax S corps on profits above a certain limit. Other states ignore the S corp election and treat the business as a C corp, which has sizable tax ramifications. Some states tax both the S corps profits and the shareholder’s profits.
- Tax Savings — Your wages as a shareholder employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.
- Business Expense Credits — Some expenses you incur can be written off as business expenses.
- Legal Separation — The business has its own life separate from its shareholders. If a shareholder leaves or sells their shares, the S corp continues relatively undisturbed.
- Process Discipline — Requires director and shareholder meetings, minutes, updates to by-laws, stock transfers and maintenance of records.
- Compensation Requirements — A shareholder must receive reasonable compensation. Otherwise, the IRS might reclassify your distributions as wages, resulting in a big audit bite.
Other Business Structures
The details above will give you a business structure for most small businesses. If you need information about alternative business types, click on these links to read more:
Need Business Structure Help?
If you don’t have a personal attorney, the experts at Legal Zoom can help you navigate the business structure maze and get your company set up.