When you’re starting or running a small business, countless questions arise, particularly surrounding your business’ legal structure:
- Is my business legal?
- What kind of business structure means I’ll pay the least in taxes?
- What happens if my business gets sued?
- What business structure is best for me?
Below is an introduction to some of the most common business structures to help you navigate this important decision.
Common Business Structures
The Sole Proprietorship
The sole proprietorship is the simplest way to operate a business. If you’re self-employed or conducting any kind of business and haven’t picked a formal business structure, then by default, you’re operating as a sole proprietor.
The biggest advantage of the sole proprietorship is that it’s simple to form and maintain. Since there’s no separation between the sole proprietorship and the owner, any income earned by the business is considered income earned by the owner. A sole proprietor owner just needs to keep track of all the business’ income and expenses and report it on a Schedule C with their personal tax return.
However, the biggest drawback of the sole proprietorship is that the owner is personally liable for any debts of the business. So if your sole proprietorship business runs into financial trouble, creditors can come after your personal property and savings. Likewise, you’ll be personally liable for any lawsuits brought against the business.
The DBA (Doing Business As)
A DBA (also called a fictitious business name, assumed business name, or trade name) isn’t actually a legal structure. Rather it’s a way for sole proprietors to use a business name without having to create a formal legal entity (i.e. corporation or LLC). This is typically the simplest and least expensive way for a small business to legally conduct business under a different name.
For example, if Jane Doe wants to open a sole proprietor floral business called “Petals by Jane,” she needs to file a DBA for “Petals by Jane.” This is basically so there’s a public record to let everyone know what individual(s) are behind a business.
The Corporation (C Corp)
A corporation is considered a separate entity from its owners. This means that the corporation (and not the owners) is responsible for any of its debts and liabilities. This is often called the “corporate shield” as it protects the owner’s personal assets from the business.
A corporation has a formal structure consisting of shareholders, directors, officers and employees. Every corporation must select at least one person to serve on its board of directors and officers are required to manage the day-to-day activities of the company. Corporations need to vote on important company issues. For this reason, the corporation is often seen as administrative overkill for the average small business, and is a better option for bigger companies who plan to go public, seek VC (venture capital) funding, or invest profits back into the company.
As a separate business entity, a corporation files its own tax returns. As a C Corporation owner, you’ll need to file both a personal tax return and a business tax return. In some cases, this can result in a “double taxation” burden for small businesses where first the business must pay taxes on its profits, and then the owners/shareholders must pay taxes on an individual level when those profits are distributed to them.
An S Corporation is a corporation that’s been designed to address this double taxation issue. An S Corporation does not file its own taxes. Rather, company profits are “passed through” and reported on the personal income tax return of the shareholders. S Corporation owners are taxed on their respective shares of the company’s profits (and these profits are not subject to self-employment tax). If an S Corporation owner works in the business, they must be paid a reasonable wage for their activities and the S Corporation must pay payroll taxes on these wages.
An S Corporation starts out like a C Corporation; then the owners elect ‘S Corporation Status’ by filing Form 2553 with the IRS in a timely manner. However, be aware that not every business can qualify to be an S Corporation. For example, an S Corporation cannot have more than 100 shareholders and shareholders must be U.S. citizens or residents.
The LLC (Limited Liability Company)
An LLC is a hybrid of a sole proprietorship and corporation. This structure is very popular among small businesses, and for good reason. The LLC limits the personal liability of the owners, but doesn’t require much of the heavy formality and paperwork of the corporation. This makes it a great choice for business owners that want liability protection, but don’t want to deal with exhaustive meeting minutes, addendum filings, or other paperwork you’d need to file as a corporation.
The LLC gives you flexibility to choose how you want to be taxed. For example, you can structure your LLC to be taxed as a C Corporation or more commonly as an S Corporation (where the business doesn’t file its own taxes).
Keep in mind that this summary isn’t an exhaustive outline of all the nuances of the various business structures. Rather, it’s an introduction to the major differences to help you start to determine what’s right for your business.
Do your own research, and possibly speak with an accountant about your specific tax situation.
Difference Concept Photo via ShutterstockMore in: Incorporation