Choosing the right corporate structure for your business will depend on a few factors, mainly the risks and potential liabilities of your line of business, how many owners you plan to have and flexibility you’ll need in raising money, the cost of taxes, and the administrative burden of some corporate structures. There are some options I won’t discuss here, such as B corporations, and sub-types of partnerships, but here are the most commonly used structures.
Sole proprietorships are the easiest to start. There’s no incorporation process or filings with your state; you can just start running your business. All of the income will pass through to your personal tax return, on the Schedule C. Be aware that you’ll pay taxes on all the income the business produces, even if you don’t take the money out of the business. If you’ll need outside funding or investments, this will be harder to get as a sole proprietor. You’ll mostly need to self-fund it. You’ll have personal liability for the business’ debt and obligations, but this is less of a concern if the business is small and in an industry where you’re not likely to be sued. In riskier industries, such as food, medicine, roofing, or daycare, you may want the liability protection of a corporation or LLC.
Partnerships are similar, except they have multiple owners. Taxes are a bit more complicated. The income passes through to the partners’ individual tax returns, but you’ll have to file a Schedule K-1 for each partner. The partnership itself won’t pay income taxes, but you’ll file an informational return, the Form 1065. Like in a sole proprietorship, the partners will have personal liability for the company’s debt and obligations. You should have a written partnership agreement to guide you in case of disputes or difficult situations down the road. The agreement should consider:
- Valuing each partner’s investment, in terms of money, other assets, and sweat equity.
- Each partner’s responsibilities and duties in the day-to-day operations of the company.
- What will happen in the event that a partner becomes disabled, dies, or gets divorced? What will happen to his or her ownership stake? Will he or she continue to get a share of the profits for a period of time?
- Can the partners be involved in other businesses? Will you restrict involvement in similar businesses that may be competitors?
- Can partners withdraw from the company? Decide in advance how you’ll value buyouts of ownership interests, or if you’d rather close down the business.
- How will conflicts be resolved?
A corporation is a legal entity that’s separate from its owners. 2 common types are C corporations, and S corporations, which have some overlap and some distinctions. Either type of corporation is liable for its own debt and obligations, rather than the owners. A corporation will exist indefinitely, even if an owner leaves the company. In the case of a partnership or sole proprietorship, the company would end, and partners may choose to start a new partnership. Corporations do require some extra administrative work and have some extra costs. You must
- File articles of incorporation and bylaws to start the company
- Elect a board of directors, even if it’s the same as the shareholders
- Have annual meetings for both the directors and the shareholders
- Keep minutes of the meetings and major decisions
- Typically, file an annual report with your state’s secretary of state’s office
There’s a cost for filing your incorporation documents and annual report, either of which may also require assistance from a lawyer. Corporations also require more accounting work, and tax preparation is more expensive than it is for sole proprietors and partnerships.
A downside of C corporations is double taxation. The corporation must file its own income tax return and pays taxes on its income. Owners then get taxed on the dividends they receive, and capital gains when they sell stock. Double taxation is averted if you use an S corporation, in which the income would flow through to the owners’ personal tax returns.
Aside from avoiding double-taxation, S corporations have some limitations:
- They are subject to the same administrative and filing requirements as C corporations (see above).
- They are limited to 100 shareholders.
- Shareholders can only be individuals, estates, and certain trusts. Partnerships and corporations are excluded.
- They can’t issue preferred stock, like a C corporation can.
- Profits and losses must be allocated to shareholders in proportion to the number of shares held. Strictly speaking, this as a “per-share, per day” basis, so it gets more complicated if an owner buys or sells share during the year.
LLCs combine some aspects of sole proprietorships and partnerships, and some aspects of corporations. The LLC is liable for its own debts and obligations unless an owner personally guarantees a debt. Income flows through to the owners’ personal tax returns and you can allocate income to owners however you like – it doesn’t have to be tied to their ownership percentage, like it is with an S corporation. An LLC doesn’t need to file a tax return, unless there are multiple owners, in which case it files an informational Form 1065. There’s also no limit on the number of owners. To start an LLC, you file articles of organization with your secretary of state, and some states also require you to file an operating agreement. An LLC does not have perpetual life – it dissolves when an owner leaves the company, unless you have provisions for buying or transferring ownership interests. Even if it’s not required, it’s advisable to have an operating agreement if there are multiple owners, similar to what I described above for partnerships.
The question of which structure is right for your business does not have a cut and dry answer. Take some time to think through the pros and cons, whether you need liability protection from a corporation or LLC, if you’ll want to raise money down the road (easiest with a corporation), and weigh those against the extra costs and administrative work.