When you are starting a business, one of the first things you’ll want to research and understand, is the various forms of business. You’ve probably heard of corporations and LLC’s — these are two of the forms you’ll want to consider putting in place for your business.
Here we’ll go into more detail on why you want set up such a business structure, as well as the most common structures and some of their pros and cons. This is not legal advice. There are a lot of nuances to this decision, so you’ll definitely want to consult a lawyer and a tax advisor before you make a final decision on which form of business to choose.
Why Consider Having A Limited Liability Entity?
The main concept behind setting up a separate business entity with its own structure is that of protecting your personal assets. As a small business owner, if you don’t set up a business entity beyond the default sole proprietorship, then you can also be personally liable for the liabilities created by your company.
For example, in the day to day operations of your company, a customer comes into your place of business, falls down and gets injured. If you don’t have General Liability insurance, your insurance does not respond, or you don’t have inadequate limits, then you may need to pay out of your own pocket for any judgments against your business in that case.
That may not be a big concern if it’s a small claim, but if it runs into several hundred thousand or even millions of dollars, you wouldn’t necessarily want that to be your personal liability. On the other hand, if you are operating your business in a limited liability entity, such as an LLC or a corporation, in most cases you’ll be shielded from personal liability.
What Are The Different Forms Of Business?
There are many forms your business entity can take. Here we will talk about the most common types of business for small businesses and some of the pros and cons of each.
Sole Proprietorship
As a sole proprietor, you have not set up a limited liability entity. The liabilities of the business are yours as well. Your personal assets are at risk. You report the earnings of your sole proprietorship on Schedule C of your federal 1040 personal income tax return, based on the profits and losses of your business. The good news is that you are able to write off the deductible expenses of your business, but the bad news, again, is that you have no personal asset protection.
Limited Liability Company Or LLC
This is the most common limited liability entity you hear about these days. If set up and run correctly, it can do a good job at protecting your personal assets, if and when that may become necessary. Ironically, if the LLC is what’s known as a single-member LLC — in other words, there is only one owner — from the perspective of the IRS, it is taxed on Schedule C of your personal income tax return, just as a sole proprietorship is. If it’s a multi-member LLC, the tax situation is a bit more complicated, but still manageable. In fact, one of the things that attracts small business owners to the LLC entity type is that it is relatively simple to set up and maintain over time.
We won’t cover partnerships separately here, as most business partnerships these days are also set up in a limited liability entity structure such as an LLP. Since we won’t cover partnerships separately here, we won’t go into the different types of partnerships, such as limited partnerships and general partnerships, but if you’re interested in delving into partnership types further, check out this Investopedia article.
Corporation
For the longest time, corporations were the most common type of limited liability business entity. They still may be, although LLC’s have become extremely popular, especially among small business owners.
Corporations come in two main flavors: S-corp and C-corp. In either case, you’ll variously see them referred to as Corporation or Inc. after the company name.
An S-corp is what’s known as a pass-through entity from a tax perspective. The corporate entity itself is not taxed. Rather, the earnings of the S-corp are “passed through” to the S-corp’s owner(s) and taxed on the owner(s)’ personal tax forms (Form 1120S).
A C-corp, on the other hand, is not a pass-through entity. The C-corp itself is taxed and then the owner and the C-corp’s employees are taxed based on what they are paid and any dividends they may receive. So, in essence, a corporation can be taxed multiple times, when you’re looking at it from the perspective of the owner(s). This is a more complex entity and tax structure and the most common one for larger companies.
Summary
There are more potential business entities (types or forms of business) than those covered here, but the above are the most common and you’ll most likely be choosing one of them when you set up your business. As mentioned at the outset, talk to a lawyer and other relevant advisors before making the final business decision on which entity type to set up. When you’re putting your business plan together, it’s no longer as simple as partnerships and corporations, so you’ll want to seek out professional advice to help you make the best decision for your situation.
Image by Shutterbug75 from Pixabay
