How to Choose Your Business Structure

“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 upfront.  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.  

Common business structures

Sole Proprietorship

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. 

Sole Proprietorship advantages

  • No formal creation process.
  • Easy to start, operate and dissolve. 
  • No separate tax return. 
  • Easy to integrate the business use of home deductions.  
  • No double taxation of profits.  

Sole Proprietorship disadvantages

  • No liability protection, except through insurance. 
  • Must pay self-employment tax on the entire profit of the business. 
  • Transfer of ownership is complex. 
  • Limited access to fringe benefits for owners.  

Sole Proprietorship is a good fit for

  • Seasonal or part-time businesses. 
  • Businesses with little liability. 
  • Home-based businesses. 

Partnerships

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.  

Partnership advantages 

  • Easy to create.
  • Can have many partners.
  • Can hold investments in other businesses and consolidate multiple lines of business. 
  • Flexible allocation of profit, loss, and distribution. 
  • No double taxation of profits. 

Partnership disadvantages 

  • Requires a separate tax return. 
  • Unlimited liability for all partners (or for a general partner if set up as a limited partnership). 
  • Difficult to dissolve or change ownership. 
  • Requires tracking of basis for partners, both inside and outside of the partnership. 
  • Partners’ share of income is subject to self-employment tax. 

Partnership is a good fit for 

  • Two established businesses that come together as one.
  • Partners who consolidate multiple entities into one. 

Limited Liability Partnership (LLP)

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. 

LLP advantages

  • Liability protection for limited partners
  • Partnership agreement determines ownership transfer rules. 
  • Partners’ liability is limited to their investment in the business. 
  • Limited partners pay self-employment tax on guaranteed payments only. 
  • No double taxation of profits. 

LLP disadvantages

  • Must have at least one general partner with unlimited liability. 
  • Limited liability status for damages can be lost in some cases. 
  • Requires a separate tax return. 
  • Requires tracking of basis for partners both inside and outside the partnership. 

LLP is a good fit for

  • Businesses with partners who are not actively involved in the business. 
  • Businesses with equity capital needs. 
  • Businesses with liability exposure. 

Limited Liability Company (LLC) 

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. 

LLC advantages

  • Simple creation process.
  • Easy to operate and dissolve. 
  • No separate tax return (if single member). 
  • Ownership in multimember LLCs can be relatively easily transferred.  
  • Easy to integrate business use of home deductions. 
  • Liability protection, except for malpractice. 
  • No double taxation of profits. 

LLC disadvantages

  • The entire profit of the business is subject to self-employment tax. 
  • Transfer of ownership can be complex. 
  • Limited access to fringe benefits for owners. 
  • Separate tax return required (if multimember). 
  • Laws regulating LLCs vary widely among states. 

LLC is a good fit for

  • Businesses with potential liability in operations. 
  • Businesses requiring equity capital. 
  • Businesses expecting ownership changes over time. 

Corporation or C-corp

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: 

  • The stock must be in a domestic C-corp (not an S-corp or LLC), and the business must have been a C-corp for most of the time that the investor owned it.
  • The corporation may not have more than $50 million in assets when the stock was issued.
  • The stock must be a part of the original issue and not bought on a secondary market.  
  • At least 80% of the value of the corporation’s assets must be used in the active pursuit of one or more qualified businesses.
  • The investor must have held the stock for at least five years.

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.  

C-corp advantages

  • No liability for non-active stockholders. 
  • No restrictions on ownership. 
  • Ownership can transfer through the sale of stock. 
  • Separate entity from stockholders. 
  • Fringe benefits for owner-officers. 
  • Can have an ownership interest in any other business.
  • Perpetual existence. 
  • Easier to raise capital. 
  • Qualified Small Business Stock tax advantage for early investors. 

C-corp disadvantages

  • Double taxation of profits. 
  • Complex and expensive to create and maintain. 
  • Require regular board of directors’ meetings and minutes. 
  • Require separate tax returns. 

C-corp is a good fit for

  • Businesses with ownership in multiple other entities. 
  • Businesses with significant liability exposure. 
  • Businesses intended to exist eternally. 

S-corporation or S-corp

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.  

S-corp advantages

  • Liability protection similar to that of C-corps
  • No double taxation of profits. 
  • Easy transfer of ownership. 
  • Separate entity from stockholders. 
  • Losses can offset shareholders’ other taxable income. 

S-corp disadvantages

  • Complex and expensive to create and maintain. 
  • Require a separate return. 
  • Require regular board of director meetings and minutes. 
  • Require tracking of basis for stockholders. 
    Ownership is limited to specific types of entities. 
  • Limits to the deductibility of fringe benefits for owner-employees.

S-corps are good for

  • Businesses with significant liability exposure. 

Business Formalities

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.  

Would you like some help? 

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.

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