When you first start a business, your mind may be swimming with an endless number of tough decisions to make. One of those – choosing the proper legal “corporate form” – can be a complicated endeavor. You do not have to overthink it, though, and your initial decision is not necessarily set in stone. Plenty of huge companies started as sole proprietorships before shifting to a more complicated corporate form, and so too, many small startups have unnecessarily burned precious startup capital on lawyers for too-complicated legal structures.
Here then are some of the basic pros and cons to think about when structuring your small business.
Sole proprietorship
Contrary to popular belief, you do not necessarily need to set up any type of formal structure before launching a business. In fact, most of us have run a sole proprietorship without even knowing it. If you ever got paid directly for babysitting or mowing a lawn, you were running a sole proprietorship. A sole proprietorship is simply a business owner who runs a business without any formal corporate structure. They simply report their profits and losses on their personal tax return (or at least they should).
Ideally, you will create a separate checking account for your proprietorship and keep good records of any profits and losses. That will be important come tax time. You should also register the name of your business with the state and you may also need local business licenses. That said, all in all, setting up a sole proprietorship requires only a very minimal amount of time, effort and expense.
The best thing about a sole proprietorship is that it is easy to create and maintain. Setting up many types of corporate forms can cost anywhere from $50 to thousands of dollars, but that is not the case with a sole proprietorship.
The biggest drawback of sole proprietorships is the potential for personal liability. For example, if you chose to incorporate your business instead, your corporation is a separate legal entity apart from you. The corporation, not you personally, is liable for the business’ debts and liabilities.
This is not true for a sole proprietorship.
If you are working as a sole proprietor and your company gets into trouble, you and your business are one and the same. For example, a woman in Pennsylvania that ran a grocery store as a sole proprietor for many years was recently forced into bankruptcy. She now personally owes her grocery store's bakers and vendors, and a judge may sell her home to try to pay the debts of her store.
The other drawback is obvious. A sole proprietorship can only have the one sole owner. If you want your business to survive you, or you want to go into business with someone else, you will need to choose another entity.
[Read our full guide on sole proprietorships]
General partnership
The easiest way for two or more people to go into business together is to form a general partnership. Like a sole proprietor, general partners usually do not need to file any formal paperwork, although having a written partnership agreement that spells out duties, responsibilities and financials is strongly advised. Partners generally share profits and losses equally, jointly run the business, invest money together, and own property together.
General partnerships are easy to form, and the profits (or losses) of the partnership are reported on the partners’ personal tax returns. One of the biggest risks of a partnership, however, is that each partner can make decisions for the whole, typically unilaterally, and yet all partners are responsible for that decision.
Similarly, as with a sole proprietorship, each partner is personally liable for the debts of the business. There is no corporate shield. Additionally, a partnership can be said to be formed by the actions of the participants even if they did not intend to start a partnership. One final big limitation with partnerships is that they are usually destroyed when one partner leaves.
[Read our full guide on general partnerships.]
Contrary to popular belief, you do not necessarily need to set up any type of formal structure before launching a business.
C corporation
A corporation is a legal entity that has two main features: (1) limited liability, and (2) infinite life. Both of these should be attractive to an entrepreneur. As indicated, limited liability is very important because it allows people to enter into a business without putting their personal assets at risk. For example, if you bought stock in Coca Cola, you would not want to personally be sued if the company sold a tainted batch of soda. Instead, if Coca Cola goes bankrupt, its shareholders would only lose the money they put into the company.
“Infinite life” means just that. A corporation can live on as long as its shareholders keep it alive. A sole proprietorship will obviously die when that sole proprietor dies or quits the business. A corporation is owned by its shareholders, though, and will carry on even as some shareholders quit, sell their shares, or die.
Corporations have a tremendous amount of flexibility in how they are formed, but probably the most important distinction for a small business is choosing a tax treatment. A "C corporation" is one that chooses to pay the corporate income tax directly to the government (as opposed to flowing through to the owner’s personal return.) Most large companies like Xerox and Amazon are C corporations, which refers to Subchapter C of Chapter 1 of the Internal Revenue Code.
Limited liability and endless flexibility. As mentioned previously, the main reason to create a corporation is to limit the liability of the business owners. A corporation can be set up in an infinite number of ways with all kinds of formal management processes in place. Additionally, major investors who often work with corporations will not get involved if the business is structured any other way.
Double taxation and complicated setup. C corps are subject to double taxation, that means that the company is taxed once on earnings, and then shareholders are taxed again on distributions. This process has been made less painful by recent changes to the U.S. tax code, but corporations in the United States are still taxed at 21%.
[Read our full article on C Corp.'s]
S corporation
S corps are often the preferred legal structure for many a small business because of
- Limited liability
- Tax savings
- Ease
S corps are "pass-through" entities, meaning, while the owners still get the benefits of limited personal liability, profits from the corporation flow through directly to the owner’s personal taxes. S corps therefore are not taxed separately. The IRS has strict requirements for S corps, but there is no actual limit on the size of an S corp.
Limited liability and tax relief. S corps come with all the limited liability benefits of any other corporation, while still allowing the business to be structured a number of ways. The IRS restricts some things for S corps that a C corp can do, though; for example, a C corp can have more than one class of stock, while an S corp cannot.
The most important thing about an S corp is that it avoids double taxation. S corps can make distributions to its owners that are not subject to income tax or self-employment taxes. In order to keep S corps from using that rule to completely avoid paying employment taxes, the IRS does require S corps to pay market-rate salaries to its owners.
A more complicated setup. S corps can sometimes be relatively complicated to set up, and simple mistakes can cost an S corp its status. A professional should usually be involved.
Limited liability company
Limited liability companies, or LLCs, are a relatively new corporate form that was invented in Wyoming in 1977 at the behest of an oil company seeking to launch a new venture that would be run like a partnership, have limited liability, and also avoid double taxation at the federal level. Wyoming did not have a state income tax at the time, so, since the state legislature did not have to worry about losing tax revenues, it agreed to try it.
Florida created a similar scheme in 1982 and the U.S. Congress started to pay attention. In a 1986 tax reform bill, Congress blessed the LLC concept, and today LLCs can be formed in every state that will be honored in every other state. In fact, LLCs have become “undeniability the most popular form of new business entity in the United States” despite being somewhat new.
The best of both worlds. LLCs were created to allow owners to enjoy all of the best parts of the other corporate forms, so they have a lot of pros.
- LLCs are easy to form, and, if used properly, provide limited liability like any other corporation. Forming an LLC is typically as easy as filling out a form and paying around $10.
- An LLC is easily managed by its members, who vote in proportion with their membership. So, if a two-member LLC is owned 60% by one member, that member basically makes all the decisions. LLCs can also have one member, making it a “single-member LLC” that runs just like a sole proprietorship but with limited liability protections.
- LLCs can also grow to have hundreds of members that oversee the business while hiring extensive teams of managers to run the business.
When set up correctly, an LLC can be taxed however you want. LLCs are often treated as “disregarded entities” where the LLC’s activities are accounted for on its owners’ tax returns, just like a sole proprietorship or partnership. LLCs can also be set up as an S corp tax-wise, or they can elect to pay corporate income taxes to avoid passing through profits and losses to their members.
The cons of an LLC are few and far between. There is some cost to creating them, typically ranging from $50 to $500. LLCs are limited in their ownership structure, as they cannot sell non-voting shares the way a corporation can. LLCs cannot deviate from being member-controlled, either. For these reasons, investors are somewhat leery of the LLC, making them unsuitable for most large businesses and for small companies hoping to grow rapidly.
[Read our full guide to LLC's]
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