When you establish a business, one of the first things you need to do is decide on the business structure. The most common types are sole proprietorship, LLC, LLC acting as an S-Corp, and S-Corp. Your decision will impact many things, including your capability to raise money, your control over business operations, and the amount you pay in taxes. Understanding the differences to compare the advantages and disadvantages of each option is the best way to ensure you make the right choice.
A sole proprietorship is the most common choice for establishing a business. It is the most obvious choice if you are a freelancer, if you want to run part-time business, and for any other type of low-liability company. You are automatically a sole proprietor if you are the only owner of your business, if no other investors or shareholders will be involved, and you have not set up any legal entity for your business.
The main advantages of a sole proprietorship is that the IRS will see your business as a “disregarded entity.” This means you will report all your business income and expenses in a personal tax return and your tax rate will be much the same as if you were employed.
It may be unnecessary to register your business at state level, depending on your location. However, you may still need to register at county, town, or another level, gain necessary local licenses, and pass relevant inspections. You will also need to register your trade name with your county clerk if it is anything but your legal name.
Despite these benefits, you may prefer to consider a different option if you need to raise money. Investors are unlikely to be interested in a sole proprietorship and banks can be hesitant to offer loans.
You should also bear in mind that there is no distinction between business and personal liability when you have a sole proprietorship. This means that your personal assets are on the line in the case of debt or a lost lawsuit. However, you can mitigate risk by purchasing business liability insurance.
LLC stands for limited liability company. In the case of a single-member LLC, the business has just one owner; a multi-member LLC has more than one owner. In either case, it is easy to split profits and responsibilities between team members. You should note that by choosing an LLC your team members will likely be subject to self-employment tax.
Unlike with a sole proprietorship, with an LLC you have personal liability for business debts and other obligations. Plus, an LLC still has the advantage of limited record keeping, which includes passing profits through your personal tax returns.
An LLC also has the advantage of being easier to form than a corporation, although the filing fees are about the same. The process involves filing articles of organization with your state and publishing a notice of formation in your local newspaper. You’ll also need to file a report with your state every year.
You should consider forming an LLC if you need liability protection, if you want to maintain flexibility in managing your business and paying taxes, or if you need to raise a small amount of money.
However, if you are looking to raise significant investor money or venture capital, an LLC is a poor choice. Furthermore, you should reconsider forming an LLC if a sole proprietorship would be sufficient. Whereas you can form an LLC as a single-person business, the extra paperwork and fees involve mean that this is only necessary if you require protection from liabilities. You should note that liability protection excludes misconduct and business loans with personal guarantees.
LLC Acting as an S-Corp
When an LLC is acting as an S-Corp, the IRS treats your business as an S-Corp just for tax purposes. This allows you to maintain the advantages of an LLC, like simpler administration (fewer forms to file and less documentation) and greater flexibility in allocating profits and losses among owners. At the same time, you receive the taxation benefits of an S-Corp. This is because whereas you are in fact an LLC, the IRS will treat your business as a physically-separate taxable entity.
All this gives you greater flexibility for paying the owners. Rather than being limited to passing earnings to the owners as self-employment income, you can divide earnings into salaries or wages and then provide passive income in the form of distributions. Only salaries and wages are subject to FICA tax. Bear in mind that you will have to pay the owners (including yourself) an appropriate salary.
To be eligible for this option, you need to set up your business as an LLC, but you must act like an S-Corp, following all the applicable rules and regulations. You need to file for S corporation treatment within 75 days of forming your LLC. This is more complex than staying as an LLC.
Finally, you have the option to become an S-Corp. This involves registering your business at state level and reporting all your income and expenses on the income tax return for your S-Corp. Every owner, investor, and shareholder will receive a K-1 that they must complete before they can begin filing a personal tax return.
One advantage of becoming an S-Corp is protection from personal liability, except in cases of misconduct or negligence, such as financial fraud. Another is benefit is the lack of double taxation, which can occur with a regular corporation. You also receive all the same savings on your payroll taxes as you saw above with the LLC acting as an S-Corp.
A third benefit is ease in raising money. This is the only option in the list where you are able to issue stock, which is something that makes your business more appealing to potential investors.
However, S-Corps do have their share of disadvantages. For one thing, you need to be a domestic corporation with no more than 100 shareholders. Only domestic individuals and some qualifying trusts can become shareholders and you can only offer one class of stock. If, at any time, your business no longer complies with these requirements, you will have to become a regular corporation, making you eligible for higher taxes.
As an S-Corp, you are also required to hold annual board meetings and shareholder meetings and you must document everything in meeting minutes. You will only be able to make decisions through formal voting at these meetings. Furthermore, you will need to maintain minutes, stock ledgers, and other documentation at your business location. Finally, you must submit annual reports and comply with other state requirements. All this could necessitate hiring an attorney, an accountant, or both.
Before coming to a decision, carefully consider all the above advantages and disadvantages of each option. Think about your need to raise capital, your risk of liability, and how you could save the most on taxes to determine the best option for you.