“What business structure do I need?” is one of the most common questions we receive.
It is also a complex one to answer. Your business structure impacts everything from how you operate your business, to the taxes you pay, to the assets you put at risk. The choice of a business structure depends on your business, your vision for your business, and the legal protections that the business requires.
You will need to choose a business structure before registering your business with the state, filing for a tax ID number, and applying for licenses and permits.
To help, I outline the business structures available and some of the advantages and disadvantages of each. However, this guide is a summary. There are many nuances that one blog post can’t cover. So, if you have any doubt, let’s talk about your plans. You can contact us here.
You can generally convert to a different business structure in the future, but there are limits and things that you should consider right up front. It is worth spending some time to understand your options and investing some money and effort in professional support to get this right from the beginning.
A sole proprietorship is the default form of business structure. If you start conducting business activities and don’t register a business, you are automatically a sole proprietor.
Since a sole proprietor is a person “doing business,” there is no separation of assets. All of your assets and liabilities, whether personal or professional, belong to you, the sole proprietor. You will be responsible for all debts incurred by the business.
You can still register a trade name, but raising money is very difficult: investors want to invest in a separate business entity, not in a personal business.
Because of these restrictions, sole proprietorships are best for very low-risk businesses, owners who are testing ideas, and hobby businesses. As a business grows, you will likely want to register an independent business entity.
Partnerships have at least one general partner with unlimited liability, and all other partners have limited liability. The partners with limited liability also have limited control over the company. A partnership agreement governs all issues of control and operations.
Partnership profits pass through to personal tax returns, and the general partner(s), the one with unlimited liability, must also pay self-employment taxes.
As a result of the unlimited liability, most partnerships register as limited liability partnerships.
Limited Liability Partnerships are similar to partnerships but extend limited liability protection to every owner. A partnership agreement governs how the business runs and profits pass through to the members (partners).
However, an LLP protects each partner from any debts the partnership incurs, and partners are not responsible for the actions of other partners.
LLPs can be an excellent choice for businesses with multiple owners, professional groups (like attorneys or accountants), and groups who want to test a business idea.
The LLC is a common business structure because of its flexibility and the liability protection that it provides.
The LLC protects the owners from personal liability. This means that your cars, house, and savings are not at risk if your LLC faces bankruptcy or lawsuits. Business assets and personal assets are separate.
You must register an LLC (and LLP) with the state, and there are filing requirements that you must comply with, but it is very doable, and the liability protections are almost always worthwhile.
Another advantage of the LLC is that profits and losses pass through to personal income, and there are no corporate taxes. However, the tax code considers active members of an LLC to be self-employed, so you will pay self-employment taxes.
An operating agreement governs how an LLC operates, and in most cases, a buy-sell agreement will clarify how members can transfer in and out of an LLC.
Since it is a separate entity, an LLC can raise money. However, it is not a great option for investors because of the flow-through nature, the lack of structure, and capital gain advantages from investing in a corporation.
A C-corp is a more formal business entity that is completely separate from its owners.
Corporations pay taxes, and the entity is legally liable for the actions of the corporation.
All corporations provide the strongest liability protection to investors, owners, and employees. Also, an employee or owner leaving a corporation has no impact on the corporation itself
The trade-off comes in record keeping and taxes. There is a much higher standard of record keeping for a corporation. You must track all of the activities of the corporation as separate from the stakeholders. There are more legal compliance requirements, and the corporation pays tax.
Everyone working for a corporation is an employee, so there is no self-employment tax. However, profits are taxed twice: first when the corporation makes a profit and second when the owners report on their personal tax returns any dividends that the corporation distributes.
For this reason, many budding businesses opt for the limited liability structures above. However, when startups raise money, they may convert to a C-corp because there are benefits to raising capital as a C-corp.
First, there is the ease of raising money. C-corps can easily raise money through the sale of stock.
And, there can be a significant tax advantage for early investors in C-corps: the Qualified Small Business Stock (QSBS).
Small Business Stock (QSBS) under Section 1202 gives a large tax break to early investors
Original investors in a company may be able to exclude a significant amount of capital gains from their taxes. This benefit can be extremely attractive to investors.
Of course, there are terms and conditions. The big ones are:
There are several caveats, but the tax benefits can be very attractive to early-stage investors and can make investing in a C-corp more attractive than investing in an LLC.
An S-corp is a variation on the C-corp that avoids double taxation. S-corps allow profits and some losses to pass through directly to owners’ personal income.
While the S-corp distinction exists at the federal level, not all states recognize S-corps as distinct from a C-corp. So, depending on where you do business, your state may not allow the tax benefits at the state level; they will treat the S-corp as a C-corp.
The advantage of an S-corp is that it is a separate entity, and it protects the owners from liability. However, it does require additional record keeping, can be expensive to maintain and is not a great vehicle for investment.
Whichever business structure you choose, an important step is to adhere to business formalities. Treat the business as a separate entity. Avoid intermingling funds, and be sure to keep good records of business activities.
The courts can decide that the corporation is a non-entity and remove liability protections if you do not follow proper procedures. Also, the IRS can recharacterize loans and capital contributions between business and owner, which can lead to significant tax consequences.
So, choose the appropriate structure and put the processes in place that ensure that structure provides the protections you expect it to.
Most of our clients are more concerned about ensuring that their business is NOT considered a hobby. The value of the deductions generally exceeds the expense of self-employment taxes.
So how do you show that you are operating a business?
The first step in demonstrating that you are a legitimate business is to be one and work as one.
Establish your business structure and act like a business.
Beyond this, the IRS will look for evidence that you are actively trying to make money. You can demonstrate your professional approach in the following ways:
Doing these things will show the IRS that you are serious about turning a profit and that they should classify your activity as a business, not a hobby.
As an added benefit, these also happen to be good business practices in general.
If you are a client and would like to book a consultation, call us at +1 (212) 382-3939 or contact us here to set up a time.
If you aren’t a client, why not? We can take care of your accounting, bookkeeping, tax, and CFO needs so that you don’t have to worry about any of them. Interested? Contact us here to set up a no-obligation consultation.
Interested in receiving updates in your mailbox? Check out our newsletter, full of information you can use. It comes out once every two weeks and you can register for it below.
Found this article helpful? Share it with your network.
Above & Beyond
New York City
2 West 45th Street, Suite 1208
New York, New York 10036
565 Taxter Road, Suite 105,
Elmsford, New York 10523
Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.
He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.
His business experience includes:
Creating and preparing financial reporting, budgeting and forecasting.
Planning and preparation of GAAP and other basis financial statements.
Providing insight on financial results and providing advice based on those results.
Jeff also has a long history of helping individuals manage their taxes and plan their finances including:
Income tax planning and strategy.
Filing quarterly and annual taxes.
General financial and planning advice.
Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.
Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.
Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004. After a career of public accounting and general management, Jody knows the value of good financials. Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.
He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles. His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.
He has a particular expertise in early-stage growth companies. His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.
Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller. He has experience across industries, which gives him a deep understanding of business.
Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.
In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.
He is an angel investor through the Westchester Angels, and has served as an advisor for many startup companies and as a mentor through the Founders Institute.
Send us a message and we will contact you as soon as possible.