4 Types of Business Structures and the Consequences of Choosing the Wrong One
By Tyler Olson, CPA, Owner of Tyler James Advisory LLC
Choosing a business structure/entity can be complicated and overwhelming. This blog is meant to simplify the process and educate you on the different types of structures. After reading this post you should be better educated and ready to talk to your advisor/council about which type will help you meet your business objectives.
Sole proprietorship
If you plan on starting a business or already have one going, no matter if you sell pencils on Etsy or have a multi-million dollar commercial real estate business, you should NOT be a sole proprietor. This form of business leaves you exposed to 100% personal liability for EVERYTHING. If you take out a business loan and can’t pay it back or someone slips on your curb walking into your store, you, and solely you, are 100% liable for the damages. If you take one thing from this blog, it should be to always register as a corporation to protect yourself and your assets.
Sole proprietorships are enticing because they require no cost to legally form as it is you, ‘you’ are the sole proprietorship. There is no distinction between you and your Company, which is why this is the most risky form of business entity. By not putting a layer of protection between you and the business, you are legally held liable for everything that the business does. It may be tempting to say ‘I am just running a small Etsy store’ or ‘I just do my friends bookkeeping on the side,’ but no matter how small the business is, you should form a type of corporation to protect yourself.
Partnership
Partnerships are similar to sole proprietorships, except with a partnership there is more than one person. Again, with a partnership there is no protection and the partners are personally liable for all actions of the business and actions of the other partners.
If you are starting a business with one or more people, this is the WORST entity to start and should never be done. In order to protect yourself and your partnership, you should seek to start a Limited Liability Corporation (LLC) or a Limited Liability Partnership (LLP). Both entity types allow you and your business partners to split the ownership, while protecting each owners personal assets.
S-Corp
An S-Corporation is the first on our list that actually provides the owners of a business protection. S-Corps are an older form of business entity that separates the owners of the business from the business itself. S-Corps are desirable because of this protection offered but have several requirements that some companies cannot meet. The following are restrictions to an S-Corporation:
No more than 100 shareholders of the Company
Shareholders must be individuals, trusts, or estates
Shareholders must be in the United States
Only one class of shares can be offered
Cannot be a financial or insurance institution
If your business meets these qualifications, then electing to be an S-Corp may be the right decision for you. Before making any choice, read the LLC description below and you will most likely realize that you should be an LLC.
LLC
A Limited Liability Corporation (LLC) is the most flexible type of business structure. This is the corporate structure I would recommend to all small businesses for several reasons. Modelled after an S-Corp, LLCs take out all the restrictions of an S-Corp, while maintaining the protective corporate structure. An LLC allows one or several owners of a company, both US and international, to be protected from the corporation. There is no restriction on number of owners or owners locations. Other LLCs, S-Corps, C-Corps, etc can have ownership in an LLC as opposed to an S-Corp, which can be crucial to companies that may be seeking investment or venture capital funding.
An LLC should be created if you want the protection of a corporation with the flexibility of a sole proprietorship or partnership. Without the rules that are required for S-Corps, LLCs provide the same protection and have more flexible operating guidelines.
C-Corp
Are you a rapidly growing company with many owners who plans to IPO in the future? Than a C-Corp is the right business entity for you. The major difference between a C-Corp and an S-Corp or LLC is the double taxation. While S-Corps and LLCs provide protection as corporate entities, for tax purposes these are considered ‘Flow-Through’ entities. This means that the IRS does not distinguish the owners from the business and all earnings and expenses from the business ‘flow-through’ to the individual owners. Now, this is not to say that legally there isn’t protection because there is, this is only for tax purposes. With a C-Corp, there is not a ‘flow-through’ component. C-Corps are taxed by the IRS as a separate entity and have to pay corporate tax on any earnings. Furthermore, the owners have to pay tax on any income distributed from the corporation to the owner. Therefore, it is called ‘double taxation’ because the corporation and the owners have to each separately pay tax on the income (assuming its distributed to the owners).
C-Corps are more complex entities with more filings and accounting work needed. I would discourage a small business from starting out as a C-Corp. Once you elect to be a C-Corp it is difficult and costly to switch back to an LLC or S-Corp. However, an LLC or S-Corp can elect to be a C-Corp if the situation arises.
Conclusion
In conclusion, there are many different entity structures that a business can run under. It is crucial to do your research and ensure you are forming your business under the most advantageous and protective way for you. In general for a small business, this is an LLC, but depending on your industry and growth plans, its could be a C-Corp. I hope you have learned under no circumstance should you operate your business without the protection of a corporation.
Disclaimer: This blog is written for purely discussion and general information. It should not be used as legal and/or tax advice. This blog is not a substitute for consulting with legal council or your CPA.