Most businesses fall into two categories: formal and informal business structures.
Formal Business Structures
Formal structures have certain attributes that make them desirable for most new business owners, including personal asset protection. A personal asset refers to anything that you own that is separate from your business, such as your house or car. Personal asset protection offers a layer of protection for your property that is separate from your business in the event your business is sued.
In addition to asset protection, formal business structures allows your business to have greater credibility from onlookers, as well as help build your business credit. Formal businesses can also be considered to be taxed under an S-Corp status. An S-Corp is not it’s own business structure, but a tax classification that either an LLC or Corporation can adopt. You can read more about S-Corps here.
Informal Business Structures
The other type of business structure is an informal business structure. Examples of informal structures include partnerships and sole proprietors.
Unlike formal structures, informal business structures are cheaper to form and maintain. This makes them great for testing out new ideas and concepts, such as new prototypes and patents.
However, informal business structures do not have asset protection, which makes them more vulnerable and risky. Informal structures are best recommended for businesses that have a smaller customer base, like friends, family, and neighbors. Informal structures are great for companies that are looking to test ideas while keeping the risk of doing business low.
Choosing a business structure is an important first step when starting a new business. Each business structure has advantages and disadvantages, so which structure should you choose for your new business?
In this video we go over each type of business structure and give you an approach for deciding on the business structure that’s right for you.
Finding Your Business Structure
In order to pick which structure works best for you, you will need to determine what qualities are best suited for your business. This can best be answered if your business needs personal asset protection.
If your business is not interested in personal asset protection, you may want to consider adopting an informal business structure, such as sole proprietorships and general partnerships. Informal structures tend to be adopted by businesses who provide products or services at lower volumes to a smaller customer base. Because there is no personal asset protection, informal business structures are best for smaller businesses with more limited risk.
If your business does need personal asset protection, it should adopt a formal business structure. Adopting a formal structure has certain advantages alongside personal asset protection, including enhanced credibility for your business, and being able to build business credit. A formal business structure can become further specialized as either a corporation or limited liability company (LLC).
Corporations vs. LLCs
A formal business structure can be further detailed as either a corporation or a limited liability company.
Corporations are best suited for businesses that are looking to raise their funds through venture capital campaigns or listing on the stock exchange. One of the advantages that corporations enjoy is being able to more efficiently carry money over between tax years, which can then be used to reinvest into the company.
However, corporations are much more complex organizations when compared to LLCs, with increased administrative overhead and more paperwork. Corporations are also subject to double taxation. Double taxation means that both the business entity and business owner needs to pay income tax to the IRS. Hence the term double taxation: the earnings of the business is taxed twice.
Unlike corporations, limited liability companies (LLC) are a much simpler business structure: they require less paperwork, less administrative overhead, and are much easier to start and maintain. While LLCs are not able to carry money over between tax years like corporations, LLCs are also exempt from double taxation.
Instead of double taxation, LLCs are subject to pass-through taxation. With pass-through taxation, the business owner is the only one that is taxed while the business as a whole is not. This means that the profits are only taxed once. This tax is further reduced by sharing the profit with LLC members in the form of a distribution.
LLCs are also very adaptable, and can elect to become corporations at a later date. LLCs are a great starting point for your business to grow.
LLC: Default Tax Structure vs. S-Corp Tax Structure
LLCs can be further specialized by the number of members that operate the LLC. These classifications are important because it is how the IRS recognizes the business for tax purposes.
As its name suggests, Single member LLCs have one member and the LLC is classified as a disregarded entity on the member’s tax return. Partnerships (otherwise known as multi-member LLCs) have multiple business members. Single member and multi-member LLCs have different tax requirements, but both benefit from pass-through taxation and can avoid double taxation on income.
For most entrepreneurs starting their business, it is not always clear how much profit they will make in the first year. For any profit that is generated, it is usually reinvested back into the company.
For new business owners, it is recommended to stick with the default tax structure for their LLC.
However, both single and multi-member LLCs can choose to be taxed as an S-Corp tax structure. You may want your business to consider becoming an S-Corp if:
- If your intent is to take all of the profits out of the company at the end of every tax year.
- You know that you will be making a sufficient profit in order to pay yourself a reasonable salary and a large enough distribution to justify the added expense of becoming an S-Corp.
- Your company meets the necessary requirements and costs to become an S-Corp.
While there are situations where being an S-Corp is more beneficial, such as if the business is consistently making a healthy profit, it is not ideal for all business models. If your unsure how much profit you will make or if you want to reinvest the profits into your LLC, it’s best to stick with the default tax structure for your LLC. Both LLCs and Corporations can decide to be classified as an S-Corp at a later time.
To learn more about the benefits and requirements for S-Corps, read our LLC vs. S-Corp article.