In this article, we discuss the various options open to you, and the pros and cons of each. Finally, we explain why making the right choice from day one is so important.
As an entrepreneur excited to get your new venture off the ground, you might be tempted to rush in to setting up business formally as a first step, without fully understanding the options available to you, and the implications of your choice. Stop! Choosing the right legal structure for your business takes some time and thought, and the answer might not be as obvious as you first thought.
If you are reading this, you are probably already understand that you have choices when it comes to forming your new business. Everybody has heard of LLCs and Corporations, and probably Sole Proprietorships, too. You might even know that different types of corporations exist (S Corporation vs C Corporation, for example). But do you really understand the differences between these, and the advantages/disadvantages of each? Did you know, for example, that an LLC can choose to be taxed as an S Corporation? It isn't as straightforward as it first seems!
Let's get some of the easier options out of the way first.
Sole Proprietor
This method of doing business certainly has the lowest barrier to entry. When you are doing business as a Sole Proprietor, you are not forming a new legal entity - you are doing business as yourself. That certainly saves on the paperwork and startup costs! Taxes are fairly straightforward to handle - your revenue and expenses are reported as self-employment income on your personal tax return, and you usually won't be liable for any 'double' taxation - meaning that you are taxed once as an individual, and there are no corporation taxes to pay (because you are doing business as yourself and there is no corporation).
Unfortunately, that's where the advantages end. Sole Proprietors lack the liability protection that other business structures offer, meaning you will be personally on the hook for all debts and other liabilities that your business is accountable for. You may be able to insure yourself against some of these risks, but ultimately the buck stops with you, and you can literally lose your house and be forced into bankruptcy. Yikes!
The Sole Proprietor also lacks the professional and credible image of other business structures, such as LLCs and Corporations. You may struggle to get customers, lenders, rental deals, business bank accounts, and other key partnerships for your business if you are not a real corporation. The degree to which is really matters really comes down to the line of business you are in.
Last but not least, there is a potential tax disadvantage too. We mentioned earlier that taxes are straightforward, and indeed they are. However, a Sole Proprietor is not able to take advantage of some of the tax savings available with other business structures - in particular, the S Corporation. While an S Corporation can return money to the owners of the business in the form of a dividend (which has a lower tax rate than self-employment income), this option simply does not exist for Sole Proprietors. Again, the degree to which this matters in reality depends on your specific business circumstances.
So what is the Sole Proprietor structure good for? Typically, it is good for very small business (such as independent contractors, a one-person operation selling their creations on Etsy, and other single-person operations). If that sounds like you, and you have no ambition to grow beyond a single-person operation, or sell shares in your business, this could be the best fit for you.
Limited Liability Company (LLC)
An LLC is a popular step up, as it blends many of the advantages of being a Sole Proprietor with some very attractive features of corporations. There is a small price to pay in terms of cost and complexity to manage, but many believe that this incremental overhead is totally worth it for the advantages of being an LLC. So what is an LLC, and what are those advantages?
An LLC is a real company and a bone fide legal entity. It shields its owners (known as LLC Members) from the liabilities of the company. This is a huge advantage over being a Sole Proprietor, because as an individual your assets are protected and separate from those of the LLC. If your LLC gets into trouble, you won't be personally liable by default (unless you signed up to personally guarantee a loan, or you unlawfully managed the company or acted recklessly or negligently).
LLCs also offer a great deal of flexibility when it comes to ownership and management. The number of Members is unlimited (unlike S Corporations, for example), and the required management overhead is lower. Members can manage the company directly or appoint managers to run the company for them. LLCs can also choose how they would like to be taxed. Taxation for LLCs can work exactly like the Sole Proprietorship, but Members can alternatively elect to have the LLC taxed as either an S Corporation or as C Corporation. Each option has its own pros and cons, depending on the nature of the business.
Last but not least, an LLC portrays a more professional and credible image than a Sole Proprietorship, which might be very important for some businesses (although not all).
The disadvantages of LLCs are quite minor when compared to the advantages. An LLC is more complex to run than a Sole Proprietorship, but not by much. If you are seeking outside investment, then an LLC might not be the way to go as many investors will only invest in corporations, where they can receive equity in exchange for their cash injection.
An LLC can be the ideal route for a small business/Sole Proprietor who wishes to benefits from the liability protections. It is also an extremely popular choice for many professional services firms such as law firms and real-estate agencies, where outside equity investment is not likely to be required.
Corporation
Corporations, like LLCs, are separate legal entities to their owners. While owners of LLCs are called members, the owners of a corporation are shareholders. One of the key differences between an LLC and a Corporation is that corporations can issue shares to support investments in exchange for equity. The shareholders of a corporation own the corporation in proportion to the number of shares they acquire. Corporations offer the same shielding as LLCs to protect the owners from the liabilities of the business (with the same caveats as above).
Corporations are more costly to set up, maintain and manage than either LLCs or Sole Proprietorships. Corporations must have a board of directors, file additional returns, have annual shareholder meetings, etc. This is typically only worth it if you expect your company to grow to a large size and/or attract significant equity investment.
As far as taxation goes, there are two main options: pass-through taxation, which works in a similar way to Sole Proprietors (with some beneficial exceptions), or double taxation. The differences are explained below:
S Corporations
S Corporations have pass-through taxation - which means company profits are taxed only once, as shareholder's personal income when they receive pay or dividends. Dividends are payments made by the corporation to its shareholders as a means of distributing the profits made by the corporation, and rewarding investors. These are attractive because individuals are taxed at a lower rate for dividends compared to regular income. In effect, as long as the S Corporation is profitable enough to pay its employees a fair market wage, and make some additional profit on top of that, an S Corporation is a more profitable setup than a Sole Proprietorship. Note, however, that the corporation must pay fair market wages before making a dividend distribution - you can't set up a single-person S Corp and pay yourself entirely in dividends.
In exchange for this special tax treatment, S Corporations are subject to restrictions around their ownership structure. For example, they can only issue one class of stock, and the total number of shareholders is strictly limited to 100. All shareholders must be residents of the United States. Furthermore, S Corporations tend to get more heavily scrutinized by the IRS, which does not take too kindly to bending the rules. One simple mistake in your accounts or with your ownership structure could be enough to have your S Corporation status taken away.
There is one final consideration before diving in to setting up your S Corp. S Corps can’t be owned by other corporations, LLCs, or trusts. For companies that are hoping to get acquired at some point, this could hurt the sale of your business.
Note: It is possible to have an LLC taxed as thought it were an S Corporation, as long as requirements are met. For a small business owner who doesn't need the additional benefits (or overheads) of a full corporation, an LLC taxed as an S Corporation can be the optimal solution.
C Corporations
A C Corporation is just like an S Corporation, with two major exceptions:
- A C Corporation does not have pass-though taxation. Profits are double taxed.
- A C Corporation does not have the same set of restrictions for classes of stock, number of shareholders, shareholder residency or shareholder type as S Corporations.
Double taxed? Yes. A corporation pays tax on its income. Individuals paid from the profits of the business (employee wages and shareholder dividends) are taxed again at the personal level. This double taxation can really eat into the profit a business owner retains, so be prepared!
Corporation Summary
In summary, Corporations are the way to go if your business has plans to go large, be significantly more profitable than is necessary to pay all of its workers, have many shareholders, get acquired, and/or to utilize equity investment. They are seen as the most professional and credible types of business, and have tax advantages in certain situations (and tax disadvantages in others). However, they come with the largest overheads to set up and maintain. Be prepared to spend thousands of dollars a year simply in housekeeping.
Other options
Other options exist, such as partnerships, trusts, estates, and non-profits. These all have specialized use cases and so we won't go into detail on these. Just know that these options exist, and do your own research if you think your business could benefits from one of these structures.
Conclusion
As you have seen, the business structure you choose could have a profound impact on your tax situation, future acquisition potential, ability to raise equity investments, credibility, overheads, and profitability. Think very carefully about all of the factors before making a decision, as making the wrong one would be a very expensive mistake - and one that could damage your business in other ways if you later try to correct it. If this is your first time setting up a business, then it would certainly be worthwhile to get some professional advice. Get in touch, we will be more than happy to help you navigate the options for your specific circumstances and get you off to the best possible start.