How you legally structure your business affects your tax status and your liability. It has a major impact on how investors, banks, and credit unions perceive your worth. So taking the time to investigate your choices makes sense.
Changing from one structure to another after you’ve been in business awhile is possible, but there is paperwork and legal tasks to perform. These tasks may include transferring licenses and permits, dissolving the entity, registering with local and state agencies, and notifying the IRS, banks, credit unions, and vendors. Plus, you might need to hire an accountant and lawyer to ensure the change properly executed.
Here is a look at the most common ways to structure your business and their ramifications.
Types of Organizational Structures
In the United States, there are four main types of business structures:
- Sole proprietorship
- Limited liability, or LLC
Each has its pros and cons.
A sole proprietorship is the way many small businesses start because it is simple to get started. As the owner, it gives you complete control over the operations of the business. Many home-based businesses and one-person consultancies choose this, as well as small shops and retail and service-based firms.
With a sole proprietorship, you need to keep your records and pay the IRS with self-employment taxes. To reduce the burden of once a year tax payment, you can spread it out in four equal payments throughout the year, using estimated tax as your basis.
This structure does have limitations. You are afforded no safety net for liability, debt, and financial obligations, so your personal assets are at risk.
However, it has tax advantages, especially helpful in the early days of a business. You can use your business losses to offset other income since everything is reported on your personal tax return.
If you join up with a colleague to put together a business, your organizational structure is the partnership. There can be two or more people in the partnership, each with an equal share of both the net profits and the net losses.
Each partner reports his income on his personal IRS tax form and pays self-employment taxes. If the partnership gets sued, each partner is personally liable for debt and obligations, as well as the actions of each of the other partners.
LLCs and S Corps
Both LLCs and S Corps are hybrids of the corporation form of organizational structuring. A corporation is the most complex of all the types. Its biggest advantage is that any liabilities and obligations get borne by the corporation, not the individual owner. Corporations are taxed as separate legal entities at specific corporate tax rates. Individual states regulate corporations.
Limited liability corporations have become popular because they offer some protection in liability cases, as the name implies, just like a corporate structure does. With an LLC, even if you are the sole person in the business, you are viewed as a member of the company, not the owner. Some LLCs are partnerships.
With an LLC, both earnings and losses are passed through to the person who owns the business, who then includes them on their personal tax return.
Subchapter S corporations, usually called S corps, can pass both losses and income on to their shareholders. This gives them a legal avenue to avoid paying federal income taxes, eliminating the chance of double taxation of the profits of the corporation.
It is wise to ask an accountant or lawyer for input as to which structure will work best for your business and the future you envision for it. As your business grows and its needs change, rest assured though that your business structure can most likely be altered to meet these changes. Many startup businesses begin as a sole proprietorship or partnership and grow into an LLC or corporation.