Business Formation: What Are They and How to Choose One
LLCs. S-corporations. C-corporations. Having trouble understanding the alphabet soup of business formation? You’re not alone!
Yet deciding which type of business formation (also known as business or legal structure) works best for your start-up is among the most important decisions you’ll make, especially when it comes to your finances and taxes, as well as your personal liability.
“Your business structure affects how much you pay in taxes, your ability to raise money, the paperwork you need to file and your personal liability,” according to the Small Business Administration.
And we’re here to help you decide the business formation that’s the best fit. First, let’s take a look at your options. Then, we’ll ask you a few questions to help you determine your course of action.
1. Sole proprietorship
Think of sole proprietorships as the easy button of business formations. You simply start doing business under your own name. Some states may require you to have a business license or a local permit, depending on your type of business, but there aren’t any filing requirements beyond those.
Because sole proprietorships are so easy to start, they’re traditionally the most popular type of business. According to the Small Business Administration, more than 70 percent of businesses in the U.S. are sole proprietorships.
You’re probably saying to yourself, “Where’s the catch?” And here it is. As a sole proprietorship, you don’t have any liability protection. That means your personal assets can be used to satisfy a business debt or legal judgment.
Plus, if you hire employees and they incur any sort of liability, you’re responsible for it, and your personal assets could be at risk.
Here’s another important financial consideration of sole proprietorships: the IRS will view you, the individual, and your business as one entity. While that means you get to avoid filing sometimes complicated corporation taxes, you miss out on deducting corporation benefits and have to pay a self-employment tax.
From both a paperwork and operations standpoint, partnerships are straightforward. States don’t require specific partnership documents, but it’s a good idea to create a partnership agreement that’s reviewed and signed by all participating partners. When opting to establish a partnership, you have three options:
- General: This is your basic partnership, as detailed above. Although paperwork and filing requirements are minimal, you should check with state and local regulations to see if you need any licenses or permits to operate.
- Limited: Think of a limited partnership as a general partnership with limited liability protection. To create a limited partnership, one partner is designated a general partner with unlimited liability. Then, other partners are limited partners, which means their liability is the same as their investment. These limited partners are typically silent partners—they invest in the business but don’t involve themselves in day-to-day operations. Limited partnerships are pass-through tax entities, so taxes are paid at the individual level.
- Joint Ventures: These are formed by two or more people who are working on a single project. As a result, they’re typically more limited in scope and length of time than a partnership, which may continue indefinitely. According to Nolo.com, the necessary elements of a joint venture include “an express or implied agreement; a common purpose that the group intends to carry out; shared profits and losses; and each member’s equal voice in controlling the project.”
Additionally, joint ventures are treated differently when it comes to taxes. Parternships are pass-through tax entities, while joint ventures can be taxed as a corporation or a partnership.
Partnerships, like sole proprietorships, don’t offer much in the way of liability protection. You’ll find the specifics of partnership liability covered by various state regulations, but most of the time, each partner has unlimited liability for any business debts or lawsuits, including those that result from actions of another partner.
The SBA has some helpful guidance on when partnerships are the best fit, including for businesses “with multiple owners, professional groups like attorneys, and groups who want to test their business idea before creating a more formal business.”
3. Limited Liability Company (LLC)
As David Ingram wrote for LegalZoom, “limited liability companies combine the advantages and disadvantages of corporations and private partnerships.”
In an LLC, business owners — referred to as members — aren’t personally liable for business debts or legal judgments. So, when you open a business bank account or take on a debt, the LLC is responsible for it, not the individual members. Additionally, LLC members have the flexibility to decide if they want to be taxed as a partnership or a corporation, unless your LLC has only one member. Then, the LLC is taxed as a sole proprietor. There’s no limit to the number of members your LLC can have, but LLCs can’t issue stock. LLCs do, however, have significant flexibility when it comes to deciding how to allocate profits and losses, which is defined in an LLC’s operating agreement.
LLCs require some set-up, but if you’re forming a simple LLC, this can usually be completed for a few hundred dollars. Be sure to check with your state first, which may have standards of LLC formation that will guide your next steps.
And that brings us to corporations, which are the most complex — and expensive — of your business formation options. Two types of corporations exist: C-corporations and S-corporations. C-corporations are considered the default because they have fewer requirements. However, S-corporations typically save on taxes because they’re treated like a sole proprietorship. “The profits (or losses) are passed through the S-corp to the shareholders, and are only taxed to the shareholders and reported on their personal tax returns,” wrote Edward A. Haman, Esq., for LegalZoom.
Both types of corporations have a lot in common. To create one, you file articles of incorporation with your state’s Secretary of State. Corporations are required to have elected directors (typically chosen from among a corporation’s owners, or shareholders), and you may have to include these names in your paperwork. Once the corporation is running, profits (or dividends) are distributed to shareholders according to the number of shares they each own. Additionally, corporation owners have limited personal liability protection because the corporation is considered a separate entity from the owners.
C- and S-corps are required to do the following:
- Issue stock
- Adopt by-laws
- Hold annual director and shareholder meetings
- Maintain meeting minutes
- Issue written resolutions for any significant decision
- File annual reports with state government
- Pay annual fees
And regardless of which type of corporation you choose, you’ll want to be sure to obtain applicable permits and licenses; register with the IRS, state and local tax agencies; and open a corporate bank account.
4. Questions to help determine your business structure
Whew! That was a lot to cover. But, we’re guessing that you might already have an idea of which business structure will work best for you.
To help solidify your decision, consider these four questions:
- Can you cover your liability? Sure, it’s anxiety-inducing, but you need to do some worst-case planning. If you incurred a significant debt or faced a legal judgment, are you in a position to cover it? If not — or if you have personal assets that you want to protect — then you’ll likely want to establish an LLC or a corporation.
- Do you need financing to start your business? Your business structure can play a key role in how easy it is to get financing. For example, most investors might be more hesitant to invest in a sole proprietorship because of a lack of formal guidelines. If you require a large amount of capital to get your business up and running, you may want to opt for a corporation, which gives investors an opportunity for an initial public offering (IPO). At the very least, consider a limited partnership, which helps protect limited partners and also frees them from the responsibility of making business decisions.
- Will you offer stock? If your answer to this question is “yes,” your way forward is clear: you need to start a corporation. Because S-corps are more complex, you can always start with a C-corp and later file the required paperwork to shift your business to S-corp status.
- Do you plan to hire employees? Your workforce is another important factor when considering liability. If you run your business as a sole proprietorship, for example, you’ll not only be personally liable for any business debts or judgments; you’ll also be responsible for any liability that results from employee actions. Even if you don’t start with employees but you know you’ll be hiring soon, consider at least an LLC to help protect yourself and your assets
If you’re feeling a bit overwhelmed by your options and how best to move forward, don’t stress — this is a big decision, and not one you want to take lightly. It might help to consult fellow entrepreneurs to get their input. You might also want to speak to a lawyer and accountant, who can make knowledgeable recommendations based on your specific situation.
You do have some degree of flexibility in terms of changing your business structure, especially if you start with something simple like a sole proprietorship. However, if you have immediate investment or employee needs, you may want to go ahead and start with at least an LLC, which gives you a slightly more formal structure without the myriad requirements and expenses of a corporation.
And remember: more help is just a few clicks away. Kauffman FastTrac, a free online course, gives you all of the information you need to start your business, including determining your business structure. Register and start the course anytime.