Small Business Formation
Choosing the best business structure for your company requires some time and careful consideration. There is no “one size fits all” business structure. Each comes with its own pros and cons such as possible annual taxes and types of protection a particular arrangement may provide. The key is to figure out which structure gives your business the most advantages to help achieve your organizational and personal financial goals. This article briefly explores the three basic types:
Sole proprietorship is the simplest form of business structure. Generally, a it is created once a person starts doing business without any formal filing with the Secretary of State. The person’s business is referred to as “Doing Business As,” or “DBA” [insert business name].
Here, there is no legal difference between you and your company; you are entirely liable as a sole proprietor for any activities related to your business. Also, any credit you obtain under the DBA is technically made to you and not a separate legal entity. This type of business structure is ideal for those who want to be their own boss or run a business from home without a physical storefront. A sole proprietorship allows the owner to be in complete control.
Limited Liability Corporation
A limited liability company is a relatively new hybrid structure with elements of a sole proprietorship and a corporation.
Unlike a sole proprietorship, LLCs provide members with personal asset protection against the company’s debts and other business-related obligations. This means that LLC owners, or “members,” are not risking their homes and other personal assets when operating the business; however, the asset protection is not complete and LLC members can still be held personally liable in the case of a lawsuit filed against the business.
The trade-off here is that forming an LLC comes with higher start-up costs. You need to file formation documents, including the Articles of Organization. Also, depending on the state, each LLC needs to pay annual fees that vary widely by state (the annual tax fee in CA is $800).
From a tax perspective, an LLC is considered a pass-through entity, which means that the business profits or losses are on the member(s) ‘s personal tax return. If the LLC has only one member, they have to file the business tax return in Schedule C of the individual tax return (exactly the same as a sole proprietorship).
Lastly on taxes, if the owner of an LLC is considered to be self-employed, you must pay the 15.3% self-employment tax contributions towards Medicare and social security. As such, the entire net income of the LLC is subject to this tax.
The law regards a corporation as a separate entity from its owners. Therefore, the owners are not held responsible for any financial hardships or lawsuits filed against the business.
A corporation has its own legal rights, independent of its owners – it can sue, be sued, own and sell properties, and sell the rights of ownership in the form of stocks. Different from an LLC, the start-up and ongoing costs (and labor) in a corporation are higher.
Corporations are required to adopt bylaws, issue stock, hold initial and annual director and shareholder meetings, and keep meeting minutes with corporate records. As you can see, this business structure is more complicated and expensive than an LLC, but the profits it generates can also be higher which makes it a good business structure for businesses that have been around for a while and are expecting to grow exponentially or businesses with shareholders.
There are two types of corporations, and taxation works differently for each:
It’s treated as a separate taxable entity by the IRS. A C-corporation is taxed at the corporate tax level, and at the personal tax level when payments are made to the shareholders. This is what is called “double taxation.”
To avoid double taxation, in an S corporation, the income and losses of the company are divided between the shareholders and pass through to their personal income taxes. Therefore, the S corporation is not taxed at the corporate level, but only the shareholders are taxed at the individual level.