Importance of small business owners choosing the appropriate business structure
MARTIN A. SCOTT, CFP®, EA
One of the most important decisions that a small business owner must make is their business structure as it has a significant impact on personal assets at risk, taxation (i.e., each type of structure has different tax implications), and growth efforts going forward (certain structures are better suited to facilitate growth). Circumstances for a business will inevitably change so note that the business structure choice can be changed in the future. I describe five different types of business structures: Sole proprietorship, Partnership, Limited Liability Company (LLC), S Corporation, C Corporation.
Sole proprietorship
Easy to form
Lower costs
Complete control
Business assets/liabilities are not separate from personal assets/liabilities (unlimited personal liability)
Taxes: self-employment, personal
Basically, sole proprietorship (one-person business) provides a small business owner simplicity, autonomy, and flexibility as it allows for full control over decision-making, operations, and profits. Setup is generally simple with minimal paperwork and low costs. Since time is so valuable to a small business owner, this sole proprietorship structure can be attractive because the person will not maintain that much of an administrative burden, which will allow more time to focus on revenue-producing activities for the business. As a one-person business, there will be limitations, but given the advancements in technology and digital marketing opportunities, there are many available opportunities for sole proprietors to establish great businesses.
Partnership
Simplest structure for two or more people to own a business together
Two types are limited partnerships (LP) and limited liability partnerships (LLP)
Limited partnerships have one general partner with unlimited liability (all other partners have limited liability)
Limited liability partnerships give limited liability to every owner (protects each partner from debts against the partnership and each partner is not responsible for the actions of other partners)
Common examples of a partnership include a business with multiple owners and professional groups (e.g., attorneys, CPAs)
Taxes: self-employment, personal
Partnerships provide small business owners the opportunity to leverage the strengths and expertise of multiple individuals (instead of just one person). A benefit of partnership could be the collaboration and compromise among co-owners when it comes to decision making, which can lead to more efficiency for the business. Additionally, there can be a level of risk sharing (e.g., financial investment, operational responsibilities, liabilities) with partnerships. On the other hand, this type of collaboration associated with partnerships can also present challenges (e.g., differences in opinion and decision-making style) that can lead to conflicts that can be detrimental to the success of the business. Effective communication is the key to addressing these challenges.
Limited Liability Company (LLC)
Protects personal assets such as home, savings accounts, and car (not at risk if LLC faces bankruptcy or lawsuits)
Profits/losses flow through to personal income
LLCs requirements vary by state
Taxes: self-employment, personal or corporate (if elected)
Limited Liability Companies (LLCs) are a choice for small business owners that are seeking flexibility, protection, and simplicity as this business structure combines the benefits of both partnerships and corporations. The main advantage of an LLC is the level of protection (separation between business and personal finances). Additionally, LLCs provide flexibility regarding management and ownership structure.
S Corporation
No more than 100 shareholders
Regarding liability, owners are not personally liable
Avoids double taxation of C corporations by allowing profits (and some losses) to flow through to personal income (without being subject to corporate tax rates)
Not all states tax S Corporations equally though
Must file with the IRS to get S Corporation status
There are certain eligibility requirements to become an S Corporation
Taxes: personal
One of the primary advantages to a small business owner who chooses the S Corporation structure is the “flow through” tax treatment, which can potentially result in significant tax savings, especially when compared to C Corporations. Additionally, S Corporations have fewer administrative burdens and compliance obligations than C Corporations.
C Corporation
Legal entity that is separate from its owners
Shareholders can leave or sell shares and C Corporation can continue doing business with no interruption
Offer strongest protection to its owners from personal liability
Higher formation cost than other business structures and has more recordkeeping and reporting requirements
Corporate profits can be taxed twice (first when company makes a profit and again if dividends are paid to shareholders on their personal tax returns)
Could provide more access to funding sources (i.e., raising money) and strategic opportunities if exponential growth is a business goal
Taxes: corporate
C Corporation is a choice for small business owners who have a goal for their business to raise funds for expansion and other initiatives as this type of structure can attract different types of investors. Regarding taxes, C Corporations are allowed certain tax deductions that are not available to other business structures. Also, C Corporations currently have a lower maximum tax rate (federal corporate tax rate is 21%) in comparison to the maximum personal tax rate (currently at 37%) applied with non-corporate business structures.
Reviewing your business structure options
I review the business structure of my small business owner clients to determine if it is suitable for their specific financial situation and goals. Specifically, I provide tax advice to each client in this area, which minimizes tax liability.