One of the first decisions that a business owner faces is what the legal structure of the business should be. There are four basically four types of structures, each with its own advantages and disadvantage. This article details each of the four types of legal business structures. It also lists some of the advantages and disadvantages of each.
The first legal structure is the sole proprietorship or general partnership. A sole proprietorship is a one-person business. A partnership is an agreement by two or more individuals to conduct business together. The advantage to these types of businesses is that they are very easy to set up because there are no significant filings for creation. Some states may require registration of a partnership and some may require both to file for a business license. But these are insignificant filings. Another advantage to just the sole proprietorship is that the income tax return for the business is part of the owner’s Form 1040 and is filed at the same time as the owner’s personal tax return, which is due on April 15. One disadvantage to the partnership is that a separate information tax return, Form 1065, must be filed for the partnership. While the partnership does not pay taxes generally, the partnership must send a schedule of share earnings to each of the partners so each of them can combine it with their tax returns. One huge disadvantage to both forms is that owners must pay self-employment tax on the business profits. This self-employment tax is currently 15.3% of profit over $600 and is in addition to paying income tax on the profits. With successful businesses, owners may pay a third or more of their profits in taxes. Another significant disadvantage occurs when the sole proprietorship or partnership incurs a liability such as a lawsuit. The owners can themselves be held liable for the liability and forced to pay the debt from personal funds.
The second legal structure is a Limited Liability Company (LLC). This is organized similar to a sole proprietorship or partnership but with some very important advantages. First, if a business is an LLC, it is a corporation and shields the owners from most liabilities. For example, if an LLC were sued and lost, the owners personally would not be held liable. However, one disadvantage to an LLC is the requirement to formally organize under state regulations. This usually requires some paperwork and filing fees during set up and each year thereafter. Another disadvantage is for tax purposes the LLC is treated like a sole proprietorship or partnership and the owners are required to pay self-employment tax in addition to income tax.
The third legal structure is a subchapter S Corporation. Named for the part of the IRS code where this structure is defined, the S Corporation has the same limited liability of the LLC. In addition owners may be treated like employees, take a reasonable wage, and then just pay income tax on the remaining profit, avoiding the self-employment tax on the profit. Shareholders, after taking and paying taxes on the salary, may take out of the business their share of the profits. The disadvantages of the S Corporation include more stringent state filings, a separate informational tax return (Form 1120S), and the issuance of stock. Generally, the S Corporation does not pay taxes but the tax return is due on March 15, not April 15, unless a fiscal year is approved by the IRS. As with the partnership return mentioned above, the S Corporation must also send shareholders notifications of each one’s share of the profits so that share can be incorporated into the shareholder’s tax return.
The final legal form is the C Corporation. Also named for its place in the IRS code, the C Corporation has less flexibility than the others. The advantages include being able to write off expenses such as officer life insurance that the previous forms cannot. But this corporation not only files its own tax return, it must pay its own taxes at a greater rate than for individuals. Owners can only get money out of this business two ways: through payroll or through dividends. Both of these are taxable. Many find the disadvantages of having a C Corporation to be far greater than the advantages.
The most common legal forms currently are the LLC and the S Corporation. These allow personal shelter from business liabilities while also providing the greatest tax advantages. For those trying to decide which form to adopt, this article provides a good starting place for making that decision. However, it may be necessary to consult an accountant or tax attorney for the best strategy.