The Difference Between Major Business Structures
When setting up your business one of the first decisions you will have to make will be how to structure your business from a tax and legal standpoint. As your business grows, however, there will be a need to re-evaluate your business structure to ensure that it is still meeting the needs of your growing company. We will look at three of the major business structures and give an overview of what they are and why a business might use one over the other.
The three major business structures are Sole Proprietorship, Limited Liability Company, and Corporation. Each of these business structures offers different advantages and disadvantages and should be chosen based on your businesses’ specific needs. The key differences in each of the structures mainly revolves around legal and tax implications. It is highly recommended that you consult with your tax accountant and/or attorney to determine which business structure is right for your business.
Sole Proprietorship (Or Partnership)
Many small businesses will start out using this method because it is the simplest method to start a business with. Other than potentially filing a business permit (depending on your local jurisdiction) there is very little else that needs to be done to declare your business as a sole proprietorship.
In this business structure you, as the owner, are the business. Without you, the business would not exist. Because of this, all business profits and losses are declared on your personal tax returns. This process is called “pass-through taxation” because your business profit and loss is passed through to your personal tax returns. If your business profits $10,000 in one year, you would simply declare a $10,000 profit on your personal tax return and that profit would be included in your personal tax liability. The benefits of this are that you do not have to pay taxes on your business profit and then again on your personal income for the same profit thus avoiding double taxation.
If you are going into business with one or more partners then this business structure would be called a partnership. This structure is essentially the same as a sole proprietorship except that it is operated by two or more people. Each partner can be either a General Partner or a Limited Partner. The general partner(s) in the business share all profits and losses equally. If the business profits $10,000 in one year and there are two general partners then each partner declares $5,000 on their respective personal tax returns. In the case of limited partners, these individuals invest in the business but do not participate in the general course of operations for the business. They are often referred to as silent partners.
The benefits of the sole proprietorship or partnership structures are that they are easier to start a business with and all profits and losses are simply filed on the owner's personal tax returns thus eliminating the need to file separate business tax returns. The downside to this business structure is that since you are the business, from a legal and tax standpoint, you are personally responsible for all losses and any liability imposed on the company.
Limited Liability Company
This structure, often referred to as a LLC, is a way for businesses to gain the benefits of the sole proprietorship structure with the added liability protection given to corporations. This method, as the name states, is a company that limits your personal liability. This business structure is popular among small businesses because it is very easy to setup and provides a decent amount of protection.
As it is with the sole proprietorship method, the LLC allows owners to “pass through” their income to their personal taxes. Owners of a LLC would then just pay taxes once on their personal taxes instead of having to pay on both their business and personal taxes, avoiding double taxation.
With the sole proprietorship business structure, you as the owner are personally liable for all losses and liabilities, whereas, with a LLC the owners are not personally liable under most circumstances. Of course, there are certain exceptions. For example, if a creditor can prove that you commingled your business and personal finances, such as sharing one bank account, then they could declare that you have “pierced the corporate veil” and essentially remove any liability protection you have. This is a major reason why you should consult with a seasoned tax or legal professional.
A corporation is a business structure that creates a distinct legal entity. In this business structure, the business is legally separate from the owner(s). A corporation is created and operated under the laws of each state and the owners are considered shareholders of the business. If you are the only owner then you simply own 100% of the shares of the corporation. Since the corporation is a separate legal entity the shareholders are not personally liable for any debt or liabilities under most circumstances.
There are two distinct differences between a corporation and a LLC in the areas of management and formalities. In most corporations, a board of directors needs to exist. These could be the actual business owners, or shareholders. This board of directors appoints officers (CEO, CFO, etc.) to oversee the actual day-to-day operations of the business. Corporations are also required to maintain a record of meetings, called minutes, with shareholders and officers. These requirements and formalities are not required with the LLC or Sole Proprietorship structure.
There are two main types of corporations: “C-Corporation” and “S-Corporation”. One of the main differences between the two is the way all profits are taxed. Under the “C-Corporation”, all profits are subject to income tax on the corporation level and then again taxed when distributed to shareholders on the shareholder’s personal level. Under the “S-Corporation”, all profits can be “passed-through” to the shareholder's personal level similar to the other two business structures. The taxes are then paid at the shareholder’s personal level and not at the corporate level.
This article is a general overview of the three main types of business structures. Each business structure’s policies are very detailed and complex and it is important for you to consult with your tax accountant or attorney to assist you with setting up the structure that is right for your business.