Selecting the correct business structure is a critical step in starting a new business, managing risk in your current business, or planning for future growth or transfer of a business. Because we work with a lot of small business owners, structure selection is a very common topic we cover in financial plans. While we see some cases where the optimal structure was chosen, we also often uncover opportunities for clients to decrease their risk or create a more stable succession plan by altering their business structure.

Setting up your business and selecting the correct structure is a complex process that often requires balancing different priorities. This blog provides an overview of the different types of business structures available to small business owners and explains the situations where each one might be advantageous. We always recommend working with a CERTIFIED FINANCIAL PLANNER™ and often a CPA prior to selecting your structure or tax filing elections.

Sole Proprietorship

A sole proprietorship is the simplest business entity and is a very common structure. Sole proprietors are individuals who own the business by themselves. The business is typically funded exclusively with an investment from the owner. As such, a sole proprietor has full control of the business. This is probably the easiest type of entity to establish and typically only involves a business license from the locality where the owner operates. Sole proprietorships are taxed as a “pass through” meaning profits or losses flow directly to the owner’s tax return. Sole proprietors are not required to obtain an Employer Identification Number (EIN), but it is often a good idea. Nolo.com has a good guide for sole proprietor EINs here.

The ease and low cost of establishment of a sole proprietorship are huge selling points when someone is starting a business, but this benefit is often offset by the drawbacks of this structure. For starters, there is virtually no distinction between the owner and the business. This means the owner faces full legal liability for the actions of the company. Sole proprietors should be adequately insured for liability with the appropriate insurance policies. These policies mitigate risk to the owner but do not eliminate the possibility the owner is found liable for a claim in excess of the limits of the insurance. Secondly, in the event the business needed equity funding in the future, the owner would need to change the structure to allow for more investors. The final major issue with sole proprietorships is the entity is legally terminated upon the owner’s death. For certain types of businesses this isn’t a major issue, but many business owners are looking for a business structure that allows for active succession planning and may wish to look at other structures.

Sole proprietorships should be considered when the following conditions are met:

• Succession planning is not a concern
• Potential liability is limited and can be covered with insurance
• Business has few employees
• Founder wishes to be the sole owner
• Simplicity of set up and low cost to establish are primary concerns

Limited Liability Company (LLC)

Limited Liability Companies are the logical progression from a sole proprietorship. The most important aspect of the LLC structure is in the name itself- the liability the owner faces is limited. While claims may be brought against the business, the liability the owners face is limited to the assets held by the business. For example, in the event of a major liability claim against the company, a judge could award the claimant all the assets of the company, but the owner’s private assets (home, cars, etc.) would not be awarded. LLCs still need to carry appropriate insurance coverages to protect the assets of the business, but the structure protects the owner’s personal assets. LLCs do not necessarily dissolve upon the death of one of the owners. The status of an LLC after the death of an owner depends on the LLC’s operating agreement and state law.

Setting up an LLC is a relatively simple process. Most states require an operating agreement or contract between the owners that specifies the amount of equity each owner holds, how and when funds will be disbursed, and other financial details. Depending on the state, there may be a few additional forms and a small fee.

Most one member LLCs are taxed in a manner similar to sole proprietorships- as a pass through. This means that profits or losses flow through to the owner’s personal tax return (reported on Schedule C). For federal income tax purposes, the IRS classifies an LLC with at least two owners as a partnership by default- meaning the business must file Form 1065 and the owners must each show their share on form K-1. However, some LLCs may wish to be treated as a C or S corporation. This can be achieved by filing form 8832. In this case they would need to file form 1120 or 1120s, respectively. Tax filings for LLCs can get very complex and we strongly recommend working with a CPA and CERTIFIED FINANCIAL PLANNER™ prior to making any tax filing or election decisions.

LLCs work best for owners desiring:

• Limited personal liability for the actions of the business
• Limited number of owners
• A structure that allows for succession planning
• Flexibility in tax filing elections

General Partnerships (GP)

A general partnership essentially functions as a sole proprietorship with more than one owner. Setting up a GP is relatively simple, but requires a partnership agreement between the partners. An oral agreement is legally acceptable, but not recommended. The partnership agreement should specify the amount of ownership attributable to each partner and the specifics of the partnership’s operations and financials. Similar to a sole proprietorship, GPs dissolve as soon as one of the partners becomes incapacitated, dies, or enters bankruptcy.

Like sole proprietorship income, partnership income is “pass through” income and flows to the owners’ personal tax returns. Also similar to sole proprietorships, GP partners are fully exposed to legal liability associated with operating the business. This is a major drawback to the GP structure. As such, the GP structure should only be chosen when the liability risk faced by the business is limited and quantifiable.

Here is when you should consider a GP:

• Limited number of owners (but more than one)
• Succession planning is not a concern
• Legal risk faced by the firm is limited and can be adequately covered with business liability insurance

Limited Liability Partnerships (LLP)

A limited liability partnership adds the limited liability benefits of an LLC to the GP structure. LLPs typically form when a general partnership wishes to convert to an LLC style structure. The LLP structure protects general partners from liability claims against other general partners. Typically, the LLP structure is used by professional services companies like law firms or dental groups.

The LLP structure should be chosen when:

• The business has already been established as a partnership and the owners wish to change the structure to limit the amount of liability they each face

Limited Partnership (LP)

Limited partnerships allow a partnership to add investors to the capital structure. These investors are known as limited partners. An LP requires at least one general partner who is directly involved in the operations of the business. The limited partners are not involved in operations and are more or less “passive” owners. Limited partners’ liability is limited to the amount of money they invested. LP income is pass through income. The general partners face full legal liability and are fully responsible for the debts of the company. LPs are often used as a type of investment vehicle for assets like real estate and oil and gas exploration and production.

LPs are useful when:

• The company is being created with the intent of bringing on outside investors
• Legal liability is limited and can be covered with insurance
• The limited partners do not wish to actively participate in the operations of the business

C Corporations (C Corps)

The C Corporation structure is used by most publicly traded companies- McDonalds, Apple, and Caterpillar are all examples of well-known C corps. The C corp structure features some of the characteristics of LLCs such as limited liability to the owners and continuity of life (the company does not dissolve upon the death of one of the owners). C corporations are typically quite complex in nature and the structure is not appropriate for most small businesses. However, under the correct conditions, organizing as a C corp can be very useful.

C corps have the advantage of being extremely flexible in their legal structure. The company may issue an unlimited number of shares and have an unlimited number of shareholders. This puts C corps at a distinct advantage in raising money through equity issuance. Furthermore, C corps may issue different classes of shares such as common and preferred as well as voting and non-voting shares.

The most impactful difference between C corps and other types of entities is the way C corps are taxed. C Corps exist as an entirely distinct tax entity. This has the disadvantage of double taxation- taxes on profits are paid once by the company and again when after-tax profits are paid out to the shareholders in the form of dividends. The current tax rate for corporations is a flat 21%. Dividends are typically (though not always) taxed at the shareholder’s capital gains rate which is either 0, 15, or 20%. Depending on the specific tax situation of each shareholder and the nature of the dividends (qualified versus nonqualified) this double taxation structure can be beneficial or detrimental. It is crucial to work with a CPA to determine exactly how the C corp structure will impact you on an individual basis.

The disadvantage of double taxation is often offset by the fact that the company can accumulate earnings. This means that although the company must pay tax yearly on its taxable income, that income does not need to be distributed to shareholders and shareholders are not liable for tax on their share of after-tax income. Accumulated earnings allow the company to use profits to do things like reinvest in the business, purchase inventory, or acquire another company without those after-tax profits flowing through to the shareholders’ personal returns the way they would with all other business structures. The amount of earnings allowed to accumulate may be limited based on several factors and a penalty may be due on accumulated taxable income if certain stipulations are not met. The rules are quite complicated and we strongly recommend you work with a qualified CPA to ensure you are meeting all the requirements to avoid penalty.

C corps work best when:

• You wish to have a large number of shareholders and raise money through equity issuance
• The business has a need to retain earnings
• There is a desire to limit the liability for the owners
• Succession planning is necessary

S Corporations (S Corps)

S corps function as a middle ground between LLCs and C corps. The income from LLCs is taxed as pass through to the owners like a sole proprietorship or a partnership, but LLCs have some of the flexibility of a C corp on stock issuance. The owners’ liability is limited. A corporation becomes an S corp when the shareholders unanimously decide to make the S corp election.

S corps can have no more than 100 shareholders and the company must be a domestic U.S. company. S Corps may issue non-voting and voting shares but can only issue common shares (common and preferred shares would not be allowed).

S corp owners who also work in the business need to pay themselves a salary for their labor. This salary is subject to employment taxes (FICA). For most S corp owners, this means that a portion of your pay will be salary and a portion will be dividend income. This can be beneficial because the dividend income will be taxed at a lower rate and is not subject to payroll taxes. IRS rules require you pay yourself “reasonable compensation.” The IRS does not have a clear set of guidelines establishing what is reasonable. For this reason, it is very important to work with an accountant to ensure your salary is high enough to satisfy the IRS. While this blog is specifically aimed at marketing agencies, it provides a good overview of reasonable compensation concepts.

The S corp election is appropriate when:

• You wish to limit the liability for the owners
• Succession planning is necessary
• The company will be domestic
• You desire 100 shareholders or fewer
• All the shareholders are individuals (shares cannot be held by trusts)

Notes for all Business Structures

There are several important things to consider when starting a business regardless of the structure you choose. Here are some of the most common recommendations we make in small business planning:

Keep a Clear Separation of Finances

• It is very common for businesses to develop as a side hustle or a hobby that turns into a money-making enterprise over time. In many of these cases, the owner starts by funding the business or hobby out of their personal checking account and never stops. This is not recommended. When setting up a business, it is very important to separate your personal assets from the assets of the business. For accounting purposes, it should be very clear when money is put into or taken out of the business. Having clear separation helps you keep a clear accounting for the business expenses. Separate accounts also help your accountant at year end and help you in the event of an audit.

Keep Enough Working Capital in the Business

• Most business owners intuitively know it takes a certain amount of capital to run their business on a day to day basis. A mistake we commonly see, however, is the owner taking too much money out of the business, then subsequently depositing more money back into the business account as the need arises. It is better to be a little more conservative and leave yourself a good cushion of working capital.

Work with an Accountant

• While a large percentage of tax payers can handle doing their taxes on their own, business accounting adds additional layers of complexity to your tax preparation. Business owners have to worry about things like payroll taxes, contributing to their employee’s retirement plans properly, and keeping track of depreciation, just to name a few. Furthermore, a good accountant will be there to look out for things business owners don’t even realize need to be tracked, often until it’s too late. A good accountant can often save you more money than you will pay them and they give you peace of mind.

Pay your Estimated Taxes on Time

• This goes hand in hand with working with an accountant. When starting their own business, many people incorrectly assume that they need to pay taxes when they file their tax return in April of the following year. Contrary to working as a W2 employee who has taxes withheld from each paycheck, business owners are on the hook for estimated tax payments throughout the year at dates specified by the IRS. The 4 “quarterly” estimated payments are due on April 15^th, June 15^th, September 15^th, and January 15^th. You’ll note that these dates are not evenly spaced and do not coincide with the end of each quarter. The easiest way to remember the dates is they start on April 15^th (the tax filing deadline) and are due in 2 months, then again in 3 months, then again in 4 months (2,3,4).

The IRS has a rather complicated set of rules regarding how much needs to be paid to avoid penalty, but suffice it to say you do not want to miss one of these deadlines or underpay. Estimated tax payments are yet another reason to work with an accountant. An accountant can not only help you calculate your estimated payment, but can also help ensure you avoid any potential penalties from the IRS. Taxes are also due throughout the year to state tax agencies (if applicable).

The IRS website has a good page on estimated payments available here.

Purchase the Appropriate Insurance

• As businesses develop from a hobby or side hustle into a full-time gig, owners often neglect to purchase insurance until it is too late. Liability coverage, even for businesses, is fairly inexpensive and can provide high levels of protection. Depending on the type of business, owners may want to consider a Business Owner’s Policy (BOP), Errors and Omissions insurance (E&O), a Business Auto Policy (BAP), or Commercial Umbrella insurance. One of the most common misunderstandings from business owners is auto insurance. Even if you have a personal auto policy on your vehicle, if you are using your vehicle for business use at the time of an accident, your personal auto policy will not apply. A BAP is necessary even when the business does not own any vehicles if employees will be driving their own cars for business purposes.

Business liability policies are necessary regardless of the liability exposure faced by the owners from operating the business. Having a legal structure that protects the owners personally does not preclude the business from facing liability suits. In the event the company is found liable for damages, the assets of the company may be awarded to the claimant. It is in the interest of all the owners to protect the assets of the company.

Consider How Long it Will Take for the Business to Become Profitable

Among the many other factors to consider when choosing how to set up your business is the length of time you anticipate it will take for the business to turn a profit and the scale of the losses as the business ramps up. This is a very complicated area of tax law and if you have reason to believe the business will have an extended period of losses, it is prudent to consult a tax expert prior to making a decision on structure.

Resources:

IRS guide to business structures:

https://www.irs.gov/businesses/small-businesses-self-employed/business-structures

IRS EIN resources:

https://www.irs.gov/businesses/small-businesses-self-employed/employer-id-numbers

Business permits and licenses in South Carolina:

https://sc.gov/business/licenses-permits-and-registration

Small Business Administration

https://www.sba.gov/