When an entrepreneur starts a business, one of the last things he or she might think about is the legal and tax structure the business should use. But while they are probably excited about their new brand—not to mention enthusiastic about serving customers and making money—choosing the right entity type (aka business structure) is vital. This can not only help them keep more of the money they earn through their business, but can also help protect them personally if the business runs into issues such as a lawsuit or tax audit.
What is a Business Structure or Entity?
A business structure defines how a business exists in a legal context. Virtually everyone in the world has heard of the term corporation, and most have at least a light concept of a partnership. But depending on the nation in which the business exists, as well as the state or local entities, the exact definition has an impact on the rights and responsibilities of the owner, shareholders, partners and other individuals, as well as tax and financial reporting requirements.
The various types of entity grow in complexity based on the individual’s protection and as the business assumes more responsibility.
According to the U.S. Small Business Administration, more than 70 % of American businesses are owned and operated by sole proprietors. This makes it the most common, and least complex, entity type, in which it is fully-owned by one individual.
In the U.S., this unincorporated structure is also sometimes referred to as a Schedule C business, because the income generated from the entity is included on Sch. C of the individual income tax return. (In some cases, the income may be reported on Sch. E or F).
Married couples may be able to have the business recognized as a qualified joint venture, with each spouse treated as a sole proprietor.
In most cases, there are no federal permits or other requirements to operate such a business if there are no other employees, as long as the income is reported to the IRS. If the owner does hire workers or contractors, a federal Employer Identification Number will be required. States and local governments may also require licenses and registration, depending on the business.
Legitimate expenses—including use of a home office, use of a vehicle, and other business costs—can be deducted from business income, with some restrictions. The income derived from the business activity will generally be taxed at the individual’s appropriate tax rate, in addition to the person being responsible for self-employment taxes. (A tax professional can provide further guidance.)
Common examples of a sole proprietorship business include landscapers, painters, caterers, housekeepers, freelancers, and gig economy workers (Uber, Lyft etc.).
- Simple to set up and manage, with little, if any, regulatory requirements.
- The simplicity of tax reporting, since the business does not directly pay tax on income, but that income is reported on the owner’s tax return.
- Owners often work a traditional job, with their sole proprietorship adding to their income.
- If the business is involved in litigation, the owner can be held individually liable (financially and criminally) for wrongdoing.
- The individual is also personally responsible for all debt incurred by the business.
Businesses with two or more owners, whether they own it equally or one has majority control, can be legally set up as a partnership.
As with sole proprietorships, partnerships are also generally easy to set up and manage but do have a few more structural requirements.
A cornerstone of the partnership, and any business entity involving more than one person, should be a document that specifically defines certain details of the business arrangement. This partnership agreement should, at the very least, include:
- The percentage of ownership of each member of the partnership
- Which person acts as the primary business officer
- What (if any) investment has been made by each partner
- How the partnership may (if desired) be terminated.
The agreement should also include details on how bookkeeping and finances will be managed, how salaries or withdrawals of funds will be managed, and how disputes will be resolved. An attorney or accountant can assist with these details.
Similar to a sole proprietorship, the business itself does not pay income taxes. However, the partnership is generally required to file a Form 1065 (a partnership income tax return) that details income and expenses. Profits shared with the partners is then reported by the partners on their individual tax returns at a rate dependent on their income level.
Also similar to sole proprietorships, the individuals involved are not protected from litigation if the business is sued. This means that, if the business is hit with a judgement of $250,000, but only has $150,000 in assets, the remainder of the judgement is the responsibility of the partners as individuals. Homes, cars and other personal assets can be lost as a result. This is why many entrepreneurs choose an alternate, although more complex, business structure.
Most partnerships are established as “general partnerships,” in which case the partners (at least two) are equal in legal position and share profits proportionately. The business can also be set up as a limited partnership, in which case only one general partner is required, along with at least one limited partner.
In a limited partnership, the general partner(s) have control over management and partnership, and are exposed to full liability risks. Limited partners do not exercise managerial control and thus are less liable for litigation or debts of the business.
Common examples of basic partnership businesses include professional services, bookkeeping, architects, lawyers, realtors, contractors, retail stores.
- Simple to manage, with only slightly more regulatory and reporting requirements, mostly for tax purposes.
- The business entity does not pay taxes on income (income is reported on partners’ tax returns).
- Sharing of profits and management decision making.
- Individual liability for debts and litigation.
- Partners may not be using the most effective tax strategies.
- Complexities in case of need to terminate a partnership or the death of a partner.
Limited Liability Company (LLC)
Limited Liability Companies have become popular with business owners because they offer a combination of easy management, along with tax advantages and some protection from personal liability for business debt.
As with sole proprietorships and partnerships, LLCs do not directly pay taxes on their income: The owners (shareholders) report the earnings they receive from the business on their individual income tax returns.
In the U.S., the business structure of an LLC is state-recognized, not federal. That means, for IRS purposes, LLCs can be treated in several ways: An LLC with a single owner is treated as a sole-proprietorship, with earnings reported on the individual’s income tax return. However, LLCs with more shareholders may be treated as a partnership, corporation or s-corporation. A tax professional is essential in determining the proper classification and reporting responsibilities.
Because of the structural flexibility and the combined benefits of simplified taxation and reduced liability, examples of LLCs include very small sole proprietorships to multi-million dollar businesses; these include Chrysler and Publix Supermarkets.
Limited Liability Partnership
Most states also offer LLPs, which are similar to LLCs but are designed with more protections for those in professional fields. For instance, they generally separate liability between partners when it comes to professional malpractice or negligence of doctors, lawyers, CPAs, architects, or other professionals. Partners of LLPs are usually required to be professionally-licensed in their field.
In general, the LLP offers the same benefits and drawbacks as LLCs, however, some states have franchise taxes that apply or may require liability or malpractice insurance. Common types of LLPs include legal and medical practices, as well as accounting firms (the Big Four global accounting firms are all established as LLPs in the U.S.)
- Increased business credibility and access to business credit, since the business has a legal organization.
- Offers some protection from individual liability, while remaining generally simple to manage.
- Pass-through taxation can simplify reporting requirements.
- Requires the legal formation of an entity recognized by the state in which it is located or does business, which includes fees and reporting requirements.
- This requires a formal structure, including articles of organization
Incorporating a business offers the most protection for its owners, providing a legal line between business and personal liability. There are two forms of corporations in the U.S., and either can be privately or publicly-owned.: C-Corporations and S-Corporations are very similar in many ways but can have very different taxation issues, and limitations on shareholder owners.
Both are separate legal entities and must be registered with state and federal government agencies, with separate legal, reporting and tax responsibilities, most notably debt liabilities and taxation of income.
The business is owned by shareholders and run by a board of directors that reports to the shareholders and is responsible for overseeing the professional managers of the business, including the CEO and other executives.
As a separate legal entity, C-Corporations pay taxes on their profits, some of which may be paid to shareholders in the way of dividends or other profit-sharing arrangements.
S-Corporations are similar to partnerships, with pass-through income, when it comes to taxation. Each individual then pays individual taxes on this income. Both types of corporations are required to file annual reports, pay corporate fees, and have written articles of incorporation and bylaws.
One of the most notable differences between C-Corps and S-Corps is that C-Corps pay taxes directly on the income the business generates (Form 1120). S-Corps do not pay tax at the corporate level. There are also differences in ownership: S-Corps can have no more than 100 shareholder owners, who must be U.S. citizens or legal residents, and S-Corps cannot be owned by another corporation, LLC or partnership. C-Corps can have any number of shareholder owners (private, or publicly-traded shares), and may be owned by another corporation.
- No liabilities for shareholders for the actions or debts of the corporation.
- If the corporation is dissolved or goes bankrupt, its debts cannot be assessed upon the individual shareholders or board of directors.
- C-Corps can be more attractive to acquisition or venture capital.
- The income of C-Corps is taxed, and then when it is distributed to shareholders by way of dividends, it must then be included as taxable income on their individual returns. Some refer to this as double taxation.
- Much more formal compliance requirements for both types of corporations than for LLCs, LLPs or sole proprietorships.
- S-Corps cannot go public or be owned by another business.
Most accounting and tax professionals are well aware of the tax implications of business entity types but may need to brush up on other aspects, as their business clients are likely to turn to them first when seeking business advice. It’s also a good idea to revisit the pros and cons of the business types every few years, or if the business experiences significant changes when it might benefit from changing its structure.
Many accounting firms also partner with a local attorney for engagements that may have legal implications. Periodic reviews of legal professional or CPE courses on business structures are advised for accounting professionals assisting clients with business formations.