Time to Read: 8 Minutes
The choice of a corporate structure for a business has many consequences: a crucial impact on the business’s taxes, your ability to raise funds, the paperwork you must file, and perhaps most important, your personal liability.
Fortunately, you can change your mind and convert to another business structure later on, but as with all legal matters, it is not that simple; switching could have a few negative impacts. For example, your state may have restrictions about these changes, and there could be tax consequences, among other issues.
Business Structure Options and Considerations
State laws mainly regulate business structures, so there are minor variations on the nuts and bolts of the rules from state to state.
U.S. state governments identify more than a dozen different types of business entities, but business owners typically choose among these six: sole proprietorship, general partnership, limited partnership, limited liability company (LLC), C corporation, and S corporation.
A sole proprietorship is the most uncomplicated business structure and easiest to form. It’s an unincorporated business owned by one person who reports business profits on their individual tax return. There are several advantages, such as giving the owner complete control of the business. Also, there is no need for major corporate formalities or paperwork requirements, such as meeting minutes, bylaws, etc. You are automatically deemed to be a sole proprietorship if you conduct business activities but do not register as any other kind of business.
The structure’s simplicity does lead to a significant shortcoming in that sole proprietorships do not create a separate business entity. This means that business assets and liabilities are not independent of your personal assets and liabilities.
A partnership is an unincorporated business owned by multiple owners, people, or other businesses. Profits are divided among its owners and reported on their tax returns. These are the simplest structure for two or more people who own businesses together. Partnerships come in a few flavors, including general partnerships, limited partnerships, limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs).
Limited partnerships have one general partner with unlimited liability, while all other partners have limited liability. The other partners usually have limited control over the company, which is noted in a partnership agreement. Profits are passed through to personal tax returns, and the general partner is also responsible for self-employment taxes.
Limited liability partnerships are similar to limited partnerships but grant limited liability to every owner. An LLP protects each partner from debts against the partnerships, and they won’t be responsible for the actions of other partners. Partnerships can be a good choice for businesses with several owners, professional groups (such as attorneys), and groups who want to try out their business idea before forming a corporation.
Limited Liability Company (LLC)
An LLC is a blended business structure that caps the personal liability of its owners — the members — like a corporation but allows taxation of the profits on either a member level or the corporate level. An LLC permits you to take advantage of the benefits of both the corporation and partnership business structures. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs, and foreign entities.
Most states also permit “single-member” LLCs, or those with one owner. The IRS explains that an LLC is a business structure allowed by state statute. Regulations may vary by state, so you must check with your state before starting an LLC.
LLCs protect you from personal liability in most cases. Your personal assets — your vehicle, house, and savings accounts — won’t be at risk of seizure if your LLC declares bankruptcy or is sued.
Profits and losses can be distributed through to a member’s personal income without facing corporate taxes. However, an LLC member is deemed to be self-employed and must pay self-employment tax contributions towards Medicare and Social Security.
LLCs can have a limited life in many states. When a member joins or leaves an LLC, some states stipulate that the LLC must be dissolved and re-formed with new membership. This can be prevented if there is an agreement in the LLC’s documents for buying, selling, and transferring ownership.
LLCs can be a good choice for medium- or higher-risk businesses, owners who want to protect significant assets, and businesspeople who want to pay a lower tax rate than they would with a corporation.
Corporation (C Corp)
A corporation, sometimes called a C corp, is a legal entity that is separate from its owners. Shareholders (the owners), a board of directors, and officers have control over the corporation. However, one person in a C corp can have all these roles, so it is possible to create a corporation and place yourself in charge of the whole company. Corporations can make a profit, be taxed, and can be held legally liable.
Corporations offer the most robust protection to their owners from personal liability, but it’s much more expensive to form a corporation than other structures. As with other entities, methods for incorporating, fees, and required forms vary by state.
Corporations also require more extensive record-keeping, operational processes, and reporting.
Unlike sole proprietors, partnerships, and LLCs, corporations are taxed on their profits. In some cases, corporate profits are taxed twice — first, when the company makes a profit, and then shareholders owe taxes when they receive dividends. Corporations have a completely independent life separate from their shareholders. If a shareholder leaves the company or sells his or her shares, the C corp can continue business operations relatively undisturbed.
Another advantage is that corporations can raise capital by selling stock, which can also help to attract top talent.
Corporations can be a good choice for medium- or higher-risk businesses, those that need to solicit funds from venture capital funds or through an IPO, and companies that plan to become public or be sold eventually.
As defined by the IRS, an S corp is a corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of an S corp report the flow-through of income and losses on their personal tax returns and are taxed at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income in contrast to the C corp. S corporations are responsible for tax on certain built-in gains and passive income at the entity level. Shareholders have limited liability.
These companies must adhere to many regulations as well, per IRS requirements. There are particular limits and strict eligibility requirements to form an S corp, and obtaining S corp status requires filing with the IRS, a different procedure than registering with the state.
For example, an S corp has one class of stock and is limited to one hundred shareholders, none of whom can be another for-profit business or a person without a green card who doesn’t meet IRS residency requirements. An S corp still has to meet the terms of corporate formalities, such as creating bylaws and holding board and shareholder meetings.
Not all states tax S corps similarly, but most recognize them as the federal government does and tax the shareholders correspondingly. Some states tax S corps on profits above an indicated limit. However, a few states do not recognize the S corp election, considering the business a C corp.
S corps can be a good choice for a business that would otherwise be a C corp, but meets the standards and requirements to file as an S corp, and can therefore take advantage of the tax provisions.
For Specific Purposes: B Corps and Non-Profits
There are a few other structures, but they are not as common as the four main ones. A benefit corporation, or a B corp, is a for-profit corporation recognized by most U.S. states. B corps are different from C corps in purpose, accountability, and transparency but are taxed in the same manner. Close corporations are similar to B corps but have a less traditional corporate structure. Most states ban them from public trading.
Finally, nonprofit corporations are formed to do charity, education, religious, literary, or scientific work. Because their work benefits the public, nonprofits merit tax-exempt status, meaning they do not pay state or federal income taxes on any profits they make. Nonprofits must file with the IRS to obtain tax exemption, a different process than registering with the state. Nonprofits are often referred to as 501(c)(3) corporations — a reference to the section of the Internal Revenue Code with rules for obtaining tax-exempt status.
Thinking Through the Tax Impact
For many businesses, taxes are a primary consideration when selecting the corporate structure. It’s important to state that sole proprietorships, partnerships, and S corporations are known as pass-through entities, as are some LLCs. In these entities, profits are distributed directly to the business owners, and that means that on April 15th, net profits are reported on the owners’ individual returns.
By default, the IRS considers LLCs as pass-through entities unless the companies elect to be taxed as a corporation.
C corporations are independent entities from their owners, so their profits are taxed at the corporate level. If a corporation distributes dividends to shareholders, which are paid with after-tax income, shareholders also owe taxes on them. Owners cannot deduct business losses on their tax returns.
For noncorporation business structures, the initial filing paperwork and fees are manageable. Owners can complete them without hiring professionals (though it’s a good idea to consult a lawyer or an accountant for help). Ongoing requirements usually come on an annual basis.
S and C corporations are much more complex entities, and these companies require the services of lawyer and an accountant. In every state, corporations must comply with a number of tax and legal requirements or face fees or penalties.
The Bottom Line
When selecting a business structure, there are three factors to study: legal liability and protection of personal assets, taxes, and administrative requirements.
The simplicity of a sole proprietorship or a partnership may be appropriate for smaller businesses or specific types goals, such as investing in real estate. However, if you are concerned about potential personal liability, an LLC or corporation may be better. Also, choosing the correct business structure requires planning about your company’s needs both now and into the future.
Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.