Choosing a structure for your business entity is one of the most important strategic decisions you’ll make as a business owner. Whether you’re starting a new business and considering how to set it up or thinking about changing the structure of your existing business, you need to understand the advantages and disadvantages of each of the types of business structures.
I’ve had too many clients come to me with horror stories when they didn’t structure their business entity correctly. For instance, clients have said things like, “Karlton, a client is suing me. I’m going to lose my children’s education funds.” Or they’ll say, “My business is struggling. I’m worried I might lose my home if things don’t work out.”
Informed business owners understand how to structure their business entities in a way that does not put their personal assets at risk. It’s important to know you can protect yourself and your personal finances. Keep reading to learn which type of business structure is best for you.
What Is a Business Entity?
A business entity is an organization created to carry out business activities. The structure of the business entity determines the tax obligation of the company and its owners. It is also a deciding factor in whether liability falls on the business or the individuals who own the business. Examples of business entity structures include LLC, corporation, partnership, or sole proprietorship.
How Does Each Business Structure Work?
The goal in setting up your business entity is to save the most money possible on taxes and separate the business from yourself as a means of protection. Learning about your options will help you understand your tax obligation and your level of personal liability involved with each of the business types.
Listed below is an explanation of a few of the most common types of business structures.
A sole proprietorship has just one owner. In this business structure, there is no distinction between the business and the owner. In other words, all income from the business is considered personal income. The business owner is subject to a personal income tax and a 15.3% self-employment tax. There are generally no initial fees or paperwork to establish yourself as a sole proprietor.
Sole proprietors are personally liable for any financial or legal trouble the business encounters. If your business is struggling, your home, savings, and other personal assets could be threatened.
Many sole proprietors are new or inexperienced business owners, so income reporting mistakes are common. Because of this, the IRS is extra vigilant in auditing these small businesses. If you run a sole proprietorship, your risk of being audited by the IRS is higher. You should always double- and triple-check your numbers when reporting your income and work with a trusted tax professional.
Just like in a sole proprietorship, there is no distinction between the business and the owners in a partnership. For this reason, business and personal income are one and the same. Additionally, owners and their income are subject to a self-employment tax. The only difference between a partnership and a sole proprietorship is that a partnership has more than one owner.
There are two types of partnerships—general and limited:
- In a general partnership, all owners are equally responsible for any liabilities of the company.
- On the other hand, limited partnerships can have one or more general partners who run operations and assume full liability for the business. But there will also be limited partners who are less involved in the day-to-day operations and are only liable for the amount they invested in the company.
The LLC is my favorite type of business structure because it has so many tax advantages and protections for small business owners. LLC stands for limited liability company. These businesses can have one or more owners.
Like a sole proprietorship or partnership, LLC owners pay self-employment taxes on the income they earn, but the business itself is not taxed on business income. LLC owners have some flexibility with how much they pay themselves. While corporation owners are required to take a salary, LLC owners can choose how much and how often they get paid.
One of the things I like most about the LLC business structure is that owners are considered separate from the business when it comes to liabilities like debts or lawsuits, which protects the owner’s personal assets.
But my top reason for picking the LLC as my favorite structure is the flexibility that allows you to reduce your taxable income. When you know how to leverage the tax laws to your advantage, setting up an LLC can save you thousands of dollars or more each tax season.
There are two types of corporations: the S corp and the C corp. The C corp is the default and most common type of corporation. C corporations are double-taxed on their income—once as a corporate income tax and again when the money is paid out to the company’s owners. But S corporations are able to avoid that double tax because they do not pay corporate income tax.
The other thing that distinguishes S corps from C corps is the requirement for S corps to have 100 or fewer shareholders, meaning these business entities cannot go public and struggle to raise venture capital.
Like LLC owners, owners of corporations are entirely separate entities from their businesses, meaning their personal assets are protected if the company experiences a lawsuit or a major debt.
Owners of corporations pay themselves very differently from LLC owners. Corporation owners are not self-employed. They are also required to pay themselves a reasonable salary, which is taxed as personal income. The money used to pay the owners of a corporation is tax-deductible, which is not the case for the money LLC owners pay themselves.
Which Structure Is Right for Your Business Entity?
All the different types of business structures have strengths and weaknesses. The structure that is best for you will depend on your specific situation. Different types of businesses have varying risks and tax needs. Keep reading to find out which of the types of business structures works best for you.
Sole Proprietorships and Partnerships
Sole proprietorships and partnerships can be a good option for business owners who are very early on in their business journey. Starting out as a sole proprietorship or partnership can allow you to test out a business venture to see if it will gain traction without committing time and money to setting up an LLC or corporation.
Sole proprietorships are for businesses that have only one owner. If you have one or more partners who will equally share ownership and liability for the business, you’ll form a general partnership. Limited partnerships are for anyone with a business partner or partners who are invested in the company but will not share full liability.
As long as you’re running a low-risk, low-profit business, it’s okay to remain a sole proprietorship or partnership. But as you grow, you’ll want to leverage the tax advantages and liability protection of a different business structure.
- Simple to establish and dissolve
- No fees to set up the business
- No separate tax on business income
- Enables business owners to easily test out a new business venture
- Increased risk to your personal assets
- Increased audit risk
- 15.3% self-employment tax
I always recommend business owners consider forming an LLC as soon as their sole proprietorship or partnerships begin to grow, make greater profits, or take on increased risks. If you have a lot of initial financial or legal risk early on, it’s a good idea to form your LLC from the very start. This will protect you and your personal finances while allowing you to take the risks that are often necessary to be a successful entrepreneur.
As a smart business owner who thinks one step ahead of the game, you also know you need to reduce your taxable income to achieve greater profits. The tax benefits of the LLC business structure are why I recommend LLCs to a majority of new business owners.
- Allows you to leverage tax laws to reduce taxable income
- Protects your personal finances
- Low cost to file the registration forms to set up the business
- Owners are subject to a 15.3% self-employment tax
- Higher start-up costs than partnerships or sole proprietorships
- The money you pay yourself is not tax-deductible
There are some serious tax advantages to structuring your business as an S corp. You can save a lot of money when the self-employment tax is eliminated. But the S corp has some start-up costs too. I always tell my clients that the benefits of becoming an S corp outweigh the costs once your business brings in a net income over $40,000.
If your business is earning a sizable profit, has fewer than 100 shareholders, is not looking to raise venture capital, and doesn’t have plans for going public, you should consider the S corp for your company’s structure.
- Save money on the self-employment tax
- Avoid being double taxed like a C corp
- The money you pay yourself is tax-deductible
- Franchise tax and corporation fees can add up to thousands of dollars
- Unable to go public
- Cannot have more than 100 shareholders
- Difficult to raise venture capital
If your company is growing and profits are rising, you may want to consider a C corp as your business structure. Business entities that want to raise venture capital or go public one day are best suited for this type of business structure.
- No self-employment taxes
- Can become a public company
- Greater ability to raise venture capital than S corps
- Unlimited shareholders allowed
- Franchise tax and corporation fees can add up to thousands of dollars
- Corporate income tax means you’ll be double-taxed on income
Changing Your Business Entity Type
Once you choose a business structure, don’t worry about being stuck with it forever. It’s incredibly common for business owners to change the structure of their business entity as the company’s needs shift and the owners learn more about business and tax strategy.
Tons of entrepreneurs start out in sole proprietorships or partnerships before switching to an LLC or corporation. The switch involves visiting your state’s business registration site, filing a few forms online with your state to register the business, and paying your registration fees. If you’re switching to an S corp, you’ll also fill out a request to the IRS.
Changing an LLC to a corporation requires a few more steps. You’ll need to change your registration and business information with your state and inform city and county tax authorities, licensing and permitting officials, as well as anyone you do business with. For more specific details about establishing an LLC, read, “How to Pay Yourself as an LLC.”
If you’re interested in starting a nonprofit corporation, read, “How to Start a Nonprofit and Incorporate It in 6 Steps.“