Choosing the right business entity, such as a corporation or limited liability company, may seem like a complicated process. This guide will show you a simple way of choosing the structure that best fits your needs and get you started actually building your business.
Here are the main factors to consider when choosing a structure for your business:
- Personal Asset Protection. This prevents you from losing your savings and other personal assets if your business is sued or goes bankrupt.
- Pass-Through Taxation. This is a type of taxation that directly levies tax on the business owner, instead of on the business and the owner (known as double-taxation).
- Self-Employment Taxes. These are the taxes all business owners pay on their income.
- Simplicity. Not all business entities are equal. Some are easier to set up and allow for more flexibility than others.
We will help you understand each of these important factors so that you can make the best decision for your business. This will also allow you to have an informed conversation with a tax professional if you choose to consult someone when forming your business.
Here are the main types of business structures you can choose from:
- Sole proprietorship: the default business structure for anyone self-employed who does not have business partners or a legal structure for their business.
- Partnership: the default business structure for anyone self-employed who has one or more business partners but no legal structure for their business.
- Limited Liability Company: One of the most popular structure for small businesses. LLCs are easier to set up and maintain than a corporation, but still offer many of the same benefits.
- C-corporation: a popular business structure for larger companies or startups that plan to seek funding from outside investors.
Now, using the above four factors, we will show you how to determine which of these options makes sense for your business.
Personal Asset Protection
One of the main advantages of having a legal entity in place is that it can shield you and other business owners from business debts and lawsuits. This is known as personal asset protection. Without a legal structure, your personal assets are at risk if your business is ever subject to any legal claims.
There are two main business structures that provide personal asset protection:
- Limited Liability Companies (these can be single-member or multi-member)
The two business structures that do not provide personal asset protection are:
- Sole proprietorships (single-owner business without a formal legal structure)
- Partnerships (multi-owner businesses without a formal legal structure)
The owners of sole proprietorships and partnerships are held personally responsible for any debts and lawsuits the business incurs. Anyone who is self-employed or who is starting a business should choose a legal structure that provides personal asset protection, like an LLC or C corporation.
Sole proprietorships and partnerships should only be used for short-term business experiments and when there is little to no risk of being sued.
Is your business currently set up as a sole proprietorship or partnership? We recommend forming an LLC for your business to benefit from personal asset protection.
Pass-Through Taxation vs. Double Taxation
The Internal Revenue Service (IRS) of the United States has created several types of business structures to facilitate the needs of different business owners. Another important factor to consider when selecting a business structure is how your company will be taxed.
Broadly speaking, there are two types of taxation that can apply to a business: pass-through taxation and double taxation.
Pass-through taxation is where the profits of the company are rolled into the income of the owner(s) for tax purposes. This means you only pay taxes once on your business earnings.
Double taxation means that both the business entity and the business owner must pay income tax. Thus, all earnings are taxed twice.
Which structures have pass-through taxation?
These business structures all have pass-through taxation:
- LLCs (Unless you specifically elect to be taxed as a C corporation)
- Sole Proprietorships
The benefit of these options is that they allow small business owners to save money on income tax.
Which structure have double taxation?
Only C corporations pay taxes on business earnings twice. In rare cases, an LLC may choose to be taxed as a C corp, in which case it would also be subject to double taxation.
Additional Factors to Consider
Do you plan to leave a large amount of money in your business account at the end of the year?
Some companies need to build up a large cash reserve to fund future projects. Others need to keep a significant amount of money in the bank at the end of December in order to pay their employees in January.
If these or similar scenarios might apply to you, then you might want to form a corporation. Corporation shareholders are not personally taxed on business income until they receive a payment, also known as a dividend.
However, as a result of pass-through taxation, LLC owners must pay tax on any money left over in a business account at the end of the year.
If so, you may want to form a corporation. LLC’s pass-through taxation status requires all LLC owners, including passive investors in the company, to pay tax on their share of LLC earnings regardless of whether or not they have received a disbursement.
For this reason, most investors prefer to work with corporations. For investors / shareholders, double-taxation works as an advantage. The corporation itself is taxed on all earnings, but individual shareholders only need to pay tax on the dividends they receive.
- Pass-Through Entities: Owners of pass-through entities (LLCs, Sole Proprietorships, and Partnerships) pay self-employment taxes on the money they earn working for their business. In addition, LLC owners pay self-employment taxes on all distributions they receive from the company.
- C-Corporations Corporation shareholders that work for the business are technically considered employees of the company. This means they don’t pay self-employment tax. Instead, the corporation pays employer taxes, just as it does for all employees.
One advantage of the LLC structure is that you can elect one of several different tax status options. Some LLC owners can save money on taxes by electing to be taxed as an S corporation.
Do you plan to earn a lot of money? More than average for someone in your field?
Like C corporations, S corp shareholders that work for the company do not pay self-employment tax. The S corp pays employee taxes on all salaries. Money that remains in the business after shareholder salaries are paid can be distributed as dividends, which are not subject to employee taxes. In some cases, this can save the company and its shareholders money on taxes overall.
However, the IRS requires all S Corporations to pay shareholders a “reasonable salary.” This means that you cannot undervalue your own work in an attempt to pay the government less tax.
Read this guide for more information about reasonable salaries.
When compared to corporations, LLCs are much simpler to set up. Corporations are legally obligated to elect a board of directors, hold annual meetings, record meeting minutes, and file certain extra paperwork. LLCs are not required to do these things unless they elect a corporation tax status.
Another benefit of LLCs is their flexibility. An LLC can be formed by a single individual, or by multiple owners. They are also able to elect different tax statuses depending on the needs of the business. You can always form an LLC at the outset and change the tax status later on to that of a C corp or S corp.
However, be careful when electing a new tax status for your LLC, since the IRS only allows you to do so once every five years.
Trade Names and “Doing Business As” Names (DBAs)
A Trade Name or DBA is not a business structure. Registering a DBA will not impact your business’ legal or tax status, nor does a DBA or Trade Name on its own provide any personal asset protection. These names simply allow you to operate your business under a name other than that of your business entity.
Start Your Business
Now that you’ve learned about the different types of legal entities, you can make an informed choice about which one is best for your needs. When you’re ready to get started, use our state-specific guides to find out how to start a business in your state. You’ll find free local business resources, popular business ideas in your state, and all the information you need to get your business up and running.
Select your State to begin
At a Glance
LLCs are best for:
- Single- and multi-member businesses that want personal asset protection
- Businesses that want pass-through taxation and don’t plan on holding a lot of money in the business account at the end of the year
C corporations are best for:
- Multi-Member businesses that want personal asset protection
- Business that are okay with double taxation and may need to hold money at year’s end in the business account
- Businesses that may receive funds from investors
Sole Proprietorships, DBAs, and Partnerships are best for:
- Entrepreneurs who are starting as an experiment and/or don’t see any likelihood of legal action