One of the most important decisions you will make when starting a business – determining the legal structure. This may affect the way you run your business. It could influence how you engage in business transactions, protect yourself against liability and minimize tax.
Here are some advantages and disadvantages of each business type:
- Sole Proprietorship. This is the most common type of business organization. It is also the easiest to form and maintain, and it offers complete managerial control to the owner. However, the owner is also personally liable for all financial obligations of the business. Before structuring your business as a sole proprietorship, you need to consider whether your business lends itself to potential liability. If you answered yes, can you afford the risk?
- Partnership. As the name implies, a partnership involves two or more people, who agree to share in the profits or losses of a business. A primary advantage is a partnership does not bear the tax burden of profits or the benefit of losses. Profits or losses are “passed through” to partners to report on their individual income tax returns. The main disadvantage is liability. Each partner is personally liable for the financial obligations of the business. Similar to a sole proprietorship, this will need to be considered prior to formation.
- Limited Liability Company (LLC). An LLC is a form of a partnership allowing owners to limit their personal liabilities, while also enjoying the tax benefits of a partnership. Traditionally, LLCs were required to have two or more members, but this has changed. You may now form a single-member LLC. One of the drawbacks to forming an LLC is the tax implications. LLC members pay self-employment taxes, which are calculated on 15.3% of profits. For other forms of businesses, self-employment taxes are due only on your salary, not your entire profits.
- Corporation. A corporation is a separate legal entity created to conduct business. It is the most complicated and expensive entity to create and maintain. The key advantage of corporate status is the avoidance of personal liability for the owners. The primary disadvantage to a corporation is the double taxation of income.
Example: Assume a corporation had $100,000 of net income in 2017 and issued a dividend of $10,000 to each of its two owners. The corporation is taxed on its $100,000 of net income, and the owners are each taxed on their dividend on their individual tax returns.
- S Corporation. One way to avoid the double taxation of a corporation is to elect to be taxed as an S corporation. Like a partnership, income and losses of an S corporation are passed through to the owners to report on their individual income tax returns. In addition, the S corporation provides limited liability for the owners. One of the biggest disadvantages to an S corporation is it is limited to the number and type of shareholder. In addition, the legal and accounting costs of setting up and maintaining an S corporation are similar to those of a standard corporation.
There are several factors you should consider when selecting a business structure – liability, tax implications, cost of formation and ongoing administration, flexibility and control. It may be problematic to switch your legal entity after you have registered, so choosing carefully at the beginning is imperative. For more information about choosing an appropriate business structure, contact a Smith Schafer professional. We look forward to speaking with you.