There are five common business structures entrepreneurs often consider as they start their businesses: sole proprietorship, general partnership, C corporation, S corporation, and limited liability company (LLC).
Which structure is “best” depends on a number of factors, such as the number of owners involved, the present and future goals for the business, whether the owners wish to limit their personal liability, and the desired type of taxation. This article summarizes each business structure based on their formation requirements, taxation, and liability of the owners, and also highlights items that are typically considered to be advantages and disadvantages of each structure. Additionally, there is a reference chart that compares the five structures in a greater variety of areas.
Sole Proprietorship A sole proprietorship is a business owned and operated by an individual, and can only have one owner. Forming a sole proprietorship is quick, fairly uncomplicated, and relatively inexpensive. The business owner does not need file documents with the state to form the business, he or she may just begin operations; however, you may still need to obtain business licenses and permits. With a sole proprietorship, the owner and the business are legally considered the same. Because of this, any profits of the business are viewed as personal profits and are taxed on the owner’s personal tax return. Additionally, the assets of the business and owner’s personal assets are legally considered the same. Therefore, personal assets, such as a home or car, could be used to satisfy business debts.
Common advantages of a sole proprietorship include:
• Creation requires relatively little time and expense.
• There are typically few ongoing requirements.
• Many states do not impose a fee for the mere privilege of existing.
• There is no separate income tax filing for the company; income and losses are reported on the owner’s personal tax return. The primary disadvantage of a sole proprietorship is:
• Because the owner and the business are legally considered the same, the owner is personally responsible for the debts of the company.
General Partnership A general partnership is an association of two or more persons operating a business for profit. As with sole proprietorships, general partnerships are fairly easy to establish. Like sole proprietorships, partnerships do not have to file formation documents with the state in order to begin operations, as do corporations and LLCs, although they may need state and/or local business licenses and permits to operate.
The profits or losses of the partnership are reported on the owners’ personal income tax returns, and any tax due is paid at the individual level. Because the owners of a general partnership are also considered to be legally the same as the business, their personal assets are not protected from the debts and liabilities of the business.
Some common advantages of general partnerships include:
• Creation requires relatively little time and expense
• There are typically few ongoing requirements.
• Many states do not impose a fee for the mere privilege of existing.
• There is no separate income tax filing for the company; income and losses are reported on the owners’ personal tax returns.
• Partners have flexibility in establishing their responsibilities, such as capital contribution, management, etc.
Some common disadvantages of general partnerships include:
• The owners and the business are legally considered the same; therefore, partners are personally liable for the debts of the partnership.
• Partners are responsible for the business-related actions of all other partners.
C Corporation The standard corporation, also called a C Corporation, is the most common corporate structure. To create a corporation, the proper formation documents, typically called the articles of incorporation or certificate of incorporation, must be filed with the appropriate state agency and the necessary state filing fees paid.
The corporation is a separate legal entity that is owned by shareholders. Because of this, the shareholders of a corporation typically cannot be held personally liable for the debts of the corporation. A shareholder’s personal liability is typically limited only to the amount the shareholder invested in the company.
With corporations, taxation is one of the primary items often weighed. C corporations may experience double-taxation. The profits of the business are reported and first taxed at the entity level. If the corporation then distributes any portion of the remaining profit to the shareholders in the form of dividends, the shareholders must then report the dividend as personal income and pay taxes on it at the individual level. This creates the double taxation of the corporation’s profits.
Some common advantages of a C corporation include:
• Shareholders are not typically personally liable for the debts of the corporation.
• C corporations can have an unlimited number of shareholders.
• The ownership of the corporation is easily transferable through the sale of stock.
• Corporations have unlimited life extending beyond the illness or death of owners.
• Certain business expenses are tax deductible.
• Additional capital can be easily raised through the sale of shares of the corporation’s stock.
Some common disadvantages of a C corporation include:
• The possibility exists for double taxation of the corporation’s profits.
• Corporations are more expensive to form than sole proprietorships and partnerships, and face ongoing filing requirements and state fees.
• Corporations face ongoing corporate formalities, such as holding and properly documenting annual meetings of directors and shareholders.
S Corporation An S corporation is a standard corporation that has elected a special tax status with the Internal Revenue Service (IRS). The formation requirements for an S corporation are the same as those for C corporation wherein formation documents must be filed with the state and the appropriate state filing fees paid.
The S corporation’s special tax status eliminates the possibility of the double-taxation that can occur with the C corporation. With S corporations, a corporation income tax return is filed, but no tax is paid at the corporate level. Instead, the profits of the corporation are “passed-through” to the shareholders and are reported on their individual tax returns. Tax is then only paid at the individual level.
As with C corporations, the shareholders of an S corporation are not typically held personally responsible for the debts and liabilities of the business.
Some common advantages of an S corporation include:
• S corporations avoid the possibility of double-taxation on the corporation’s profits.
• Shareholders are typically not personally responsible for the debts and liabilities of the corporation.
• Most other advantages of the C corporation also apply to the S corporation.
Some disadvantages of an S corporation include:
• The IRS imposes restrictions on who can be a shareholder of an S corporation: shareholders must number fewer than 100; must be individuals, estates, or certain qualified trusts; and cannot be non-resident aliens.
• S corporations can have only one class of stock (disregarding voting rights).
• All shareholders of the corporation must consent in writing to the S corporation election.
• Corporations are more expensive to form than sole proprietorships and partnerships, and face ongoing filing requirements and state fees.
• Corporations face ongoing corporate formalities, such as holding and properly documenting annual meetings of directors and shareholders.
Limited Liability Company (LLC) The LLC is a distinct business entity that offers an alternative to partnerships and corporations by combining the corporate advantage of limited liability protection with pass-through taxation. To form an LLC, the appropriate formation documents, often called the articles of organization or certificate of organization, must be filed with the state and the appropriate state filing fees paid.
The LLC typically also experiences pass-through taxation. The LLC’s income is not taxed at the entity level; however, the LLC does complete a tax return. The income or loss of the LLC as shown on this return is passed through the LLC and is reported on the owners’ individual tax returns. Tax is then paid at the individual level.
As with corporations, the LLC is also legally considered to exist separately from its owners, which are called members. Therefore, the members cannot typically be held personally responsible for the debts and liabilities of the LLC.
Some common advantages of LLCs include:
• LLCs have pass-through taxation.
• Members are not typically held personally responsible for the debts and liabilities of the LLC.
• LLCs typically have no restrictions on the number of owners (members) allowed.
• Members have flexibility in structuring the management of the company.
• The LLC does not require as much annual paperwork and have as many formalities as corporations and S corporations. Some disadvantages of LLCs include:
• LLCs are more expensive to form than sole proprietorships and partnerships.
• Ownership is typically harder to transfer than with a corporation.
• The life of an LLC may be limited, as some states still require a dissolution date to be included in the formation documents.
• Because the LLC is a newer business structure, there is not as much case law to rely on for determining precedent.
How Do You Incorporate a Business? If you decide to form a corporation, LLC, nonprofit, or limited partnership you will need to file the necessary documents, often called the certificate or articles of incorporation for corporations or the certificate or articles of organization for LLCs, with the state in which you wish to form your business. All states impose state filing fees that must be paid to form your business there. These fees vary by state and entity type, but range from $50 to over $500.
If you would like to come in to talk about setting up or converting your business structure then please call or email us and we can arrange a meeting. As always, we want to help you with all of your accounting and tax needs, stop by, call, or email us today.
If you would like to come in to talk about setting up or converting your business structure then please call or email us and we can arrange a meeting. As always, we want to help you with all of your accounting and tax needs, stop by, call, or email us today.
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