If you are thinking about starting a business, or if you’re a serial entrepreneur adding a new line of business, one of the first things you’ll have to do is to determine your business legal structure.
The four most common types and basic forms of business legal structures in the United States include:
- Sole Proprietorship
- Limited Liability Company or an LLC
This post is intended to help you understand which option may be the best fit to meet your business and personal goals and to explain the key differences among the various business structures.
Legal Structure of a Business Plan
A business’s legal structure is a key component in any business plan. Before you can build or start your new business, you’ll need to determine what legal structure will best suit your fledgling enterprise.
In certain cases your choice of a business legal structure will determine which income tax forms you will file annually. It will also determine the type of income taxes you’ll pay on the business’ net income and, more importantly, will have a big impact on the personal liabilities you and your family may face as a consequence of business ownership.
And if you intend to sell your business, its legal structure also will have an impact on many aspects of the sale process and the taxes you eventually will be required to pay.
Sole Proprietorship Definition
A sole proprietorship is a business that is owned by one individual and who has not formed any type of business entity such as a partnership, LLC or corporation. As a sole proprietor, an individual assumes a business identity by selling products or delivering services to others under his or her personal legal name.
Small businesses with a single owner are considered to be a sole proprietorship by default unless they officially form a separate, legal business entity. Owners of a sole proprietorship files their business taxes in conjunction with their personal taxes on a Federal Schedule C.
If an individual wants to use a name for their business activities which differs from their legal individual name, they must file for a fictitious name for the sole proprietorship. A fictitious name is also known as a DBA which is an acronym for ‘Doing Business As’. Those whose chose this type of trade name for their sole proprietorship do not gain any additional protections from legal liability. The fictitious name certificate merely grants the sole proprietor the right to use the alternative DBA trade name on his or her business signs, invoices, investment accounts, leases, business contracts, business checking accounts, etc.
Choosing to be a sole proprietor means the individual owner accepts unlimited liability for the business along with all of its debts, including all known and unknown liabilities. This type of unlimited liability exposure means that in the event the business faces a lawsuit, or does not have the ability to pay any of its debts, the owner’s personal property, assets, and other income will be at risk in addition to the business’s assets.
The unlimited liability nature of a sole proprietor is due to the fact there is no legal separation between the income, assets, and liabilities of an individual and business. Whatever is owned by the individual, including any assets and income built up or earned in the sole proprietor’s business is accessible to any creditor of the individual. The reverse is also true.
Sole Proprietor Tax Treatment
Many people mistakenly believe that if they do not have a business entity formed and they sell products or their services to others, they do not have to report their income and expenses to the IRS. This is not the case. By default, people in this situation are considered to be operating a sole proprietorship.
The advantage to a sole proprietorship is that the owner doesn’t need to file taxes separately or comply with any special government filings or ongoing reporting. However the disadvantage of a sole proprietorship is that if something goes wrong on the business side (debts, liabilities or legal problems), the individual owner may lose both business and personal assets and income. And if the individual or his or her spouse are sued outside of the business, any assets and income associated with a business operated as a sole proprietorship are at risk of loss.
Partnerships are essentially two or more sole proprietorships operating under a single entity. If two or more individuals begin working together in a business operation and have not formally formed a partnership, LLC or Corporation, by default, the business operation is regarded as a General Partnership.
Partnerships establish one General Partner and he or she has unlimited liability for the partnership. Conversely, a Limited Partner’s personal assets are at risk only to the extent of the Limited Partner’s investment in the business.
One of the major advantages of a partnership is that more owners often will result in more resources. Together, multiple owners can pool capital, skill sets, and networks to create an advantage as they operate their business.
Business Partnership Agreement
One of the largest risks associated with operating a business as a partnership is if a partner makes a serious mistake which has legal ramifications or otherwise no longer works amicably within the business relationship. For this reason, it’s very important to take the time to carefully draft and execute a partnership agreement to address important partner matters such as compensation, distributions, retirement, buy-sell arrangements, disability and other potential dispute-resolution methods.
Partnership Tax Treatment
Partnerships are required to file a federal tax return every year. And in most states, a similar tax return is often required. A Federal form 1065 is filed on behalf of the partnership and its partners. The income (or losses), certain deductions, and guaranteed payments paid to the partners from the partnership are passed through to the partners. Each partner receives a federal form 1065 K-1 that identifies the items of income and expenses which should be reported on the partner’s individual federal tax return.
Limited Liability Company or LLC Definition
An LLC offers the best of two worlds. It is taxed like a sole proprietorship yet it offers limited liability protections for its members, similar to those protections offered to shareholders of a corporation.
LLC owners are called members and they may use losses incurred by the LLC to offset income up to the total amount the owner has invested, but not more.
In the event the business runs into legal or financial trouble, the owner’s personal assets have more protection than those of a sole proprietorship – however that protection is limited.
And LLCs may be subject to additional state and/or franchise taxes separate from its member/owners.
Limited Liability Company Advantages
If you’re contemplating the formation of an LLC over a sole proprietorship, note the LLC will offer you more personal liability protection and be perceived by customers, vendors, employees, and others as an established business operation.
In addition, LLCs are simpler to form than a Corporation and generally cost less to operate from an administrative perspective. LLCs also offer members much flexibility regarding how profits and losses are shared between members and how distributions may be made.
Limited Liability Company Operating Agreement
One of the key steps a business owner should take when forming an LLC (either as a single-member LLC or as a multi-member LLC, is the development of an Operating Agreement for its member(s).
The LLC Operating Agreement should spell out clearly what is expected of members, which members have what roles and responsibilities, how profits and losses will be shared, how and when distributions may be made, and how ownership may be bought or sold in the future, among other important matters.
Limited Liability Company Tax Treatment
LLCs are taxed on their profits for federal tax purposes in one of several ways:
- By default, a single member LLC is treated as a sole proprietorship and if it has multiple members, the LLC is treated as a partnership; and alternatively
- If elected separately, the LLC may choose to be treated as a C Corporation, or as an S Corporation for federal tax purposes.
Most states automatically recognize the same tax treatment or any alternative elections, however it’s wise to verify this with the state in which your Limited Liability Company is formed and/or conducts its business.
A corporation is a separate legal and taxable entity, which is independent from its owners who are called shareholders.
Because the business is treated as a separate legal entity, there is less risk to the owner’s personal assets. Corporations may have one or many shareholders, all of whom have the right to profits through dividends in the form of cash and/or additional shares of stock, but who are not held personally liable for the business’s debts and legal issues.
If you have (or plan to have) more than one business under your ownership, read more about how multiple business structures can face different tax consequences here.
One of the biggest differences between a corporate structure and all other forms of business structures is the formalities the officers and directors must maintain to retain the corporation’s independent, or separate legal status from its shareholders.
Such formalities start when the business is formed. A corporation must file formal Articles of Incorporation, hold a meeting of its shareholders to authorize the formation of the business entity, issue shares of stock (certificates) to its shareholders, publish a formation notice in one or more legal journals, to name a few.
Any time a decision is made by the corporation’s Board of Directors or Officers, such a decision must be voted upon, approved, and recorded in the Corporate Minutes. And everything must be entered into the corporation’s books and records.
Holding an Annual Meeting of the Shareholders is also a requirement and so is the documentation of any decisions made at the meeting.
By default a corporation is treated for federal tax purposes under U.S. Title 26; Subtitle A; Chapter 1; Sub Chapter C (the C Corp).
C Corporations are taxed solely on their income and the business’s income and losses are not reported on the owner’s personal tax returns. A federal tax form 1120 is filed by the corporation each year.
Distribution of corporate dividends received by the shareholders of a corporation are taxable at the federal level and in most cases at the state level.
If by election, the shareholders of a corporation choose to elect Sub Chapter S federal tax treatment, then the income, expenses and certain other tax credits will not be taxed at the corporation’s level. Instead, they pass-through to the shareholders according to their respective ownership percentage and each shareholder reports these on their personal tax returns.
When a corporation has elected Sub Chapter S tax treatment, then a federal form 1120S is filed by the corporation each year and each shareholder receives a federal schedule K-1 to report his/her pro-rata share of the business income on their personal tax return.
Each state has its own rules with regard to how C Corporations and S Corporations are treated for tax purposes. In some states, additional franchise taxes are also paid by corporations, regardless of their federal tax status.
Other Various Business Types and Structures
Benefit Corporations are relatively new in the United States and are not recognized in all states. It is a for-profit business entity (which means it pays income taxes on its profit) while its purpose must have a positive impact on society and/or the environment.
Limited Liability Partnership – LLP
LLPs are similar to a Professional Corporation as they are suitable for those employee-owners who provide certain services. The underlying business entity in the case of the LLP is a partnership and not a corporation.
A non-profit entity is not a separate business entity at all. Instead, it is a corporation which has applied for and obtained permission from the Internal Revenue Service to be treated under one of the non-profit tax codes. This designation as a non-profit by the IRS is only awarded after a lengthy application and vetting process. Upon its award, the corporation is no longer subject to federal income taxes.
Professional Corporation – P.C.
When employee-owners provide personal services in the fields of accounting, actuarial science, architecture, consulting, engineering, health, veterinary, law, and the performing arts, the corporation is considered to be a Professional Corporation and is subject to specific tax rules which differ from the rules applicable to C Corporations and S Corporations.
Professional Limited Liability Company – PLLC
Similar to a Professional Corporation, the PLLC may be used when employee-owners provide certain personal services under a Limited Liability Company entity structure.
Certain states permit a single LLC to be formed and to serve as the master of a series of LLCs. Each LLC in the series is called a cell.
For those states which offer this form of multiple business structure, the LLC cells held in the series are considered to be a single entity from a legal perspective.
This form of multiple LLC structure is relatively new and is not recognized in all states. Recently, the IRS has been attempting to simplify the taxation of Series LLCs. With that said, caution should prevail as there is little case law supporting the limitation of liability when a Series LLC’s business operations cross state lines.