If you’ve decided to establish your own business, you’ll need to first choose a name for it and then decide on the ideal corporate structure for it. While you have a lot of alternatives when it comes to choosing a structure, if you don’t have any business associates, you normally have four possibilities, ranging from a sole proprietorship to a full-fledged corporation. The way you set up your business may have a big influence on things like your tax bill, how you protect personal assets, and your risk of corporate liability.
Choosing the appropriate corporate structure is an important aspect of running a business. Whether you’re just starting or expanding your business, it’s critical to understand your choices, and having a corporate attorney on your side will make the process go more smoothly. Since the structure you pick will have an impact on how your business is taxed and how much you (and other owners) can be held personally accountable, we give you an overview of the different corporate structures and their implications.
Corporate Structures and Liabilities
The purpose of a thorough asset-protection strategy and the right corporate structure is to secure your business and protect your personal assets against creditors’ claims in an effort to avoid or considerably decrease risk. An asset-protection strategy is putting legal measures in place before a lawsuit or claim develops to deter a potential claimant or prevent your assets from being seized after a judgment. Don’t wait to put your asset-protection strategy in place if you haven’t already. The longer a strategy has been in place, the more powerful it is likely to be. Separate legal entities or arrangements, such as companies, partnerships, and trusts, are employed in asset-protection planning. The arrangements that will work best for you are largely determined by the chosen corporate structure.
A limited liability company (LLC) is the most common, straightforward, and efficient option to shield oneself from personal liability.
Informal Business Structures: Sole Proprietorship and Partnership
Tax advantages and personal liability protection are not provided by informal business structures. Informal business structures can be divided into two categories:
Sole proprietorship. A business that isn’t technically formed and is owned by a single person. A sole owner is individually accountable for any measures undertaken against the business and files taxes in his or her name.
General Partnership. A business that isn’t technically established and is owned by several people. A general partnership files taxes in the names of the partners, and the partners are responsible for any actions taken against the company.
What is the Difference Between a Sole Proprietorship and a Partnership?
You can create your firm just by operating it if you don’t plan to make a lot of money or be held accountable for an injury, for example. A sole proprietorship is not required to register with the government in most states.
General partnerships must register their business names in the states in which they operate.
When Should You Form a Partnership or a Sole Proprietorship?
For businesses with the following features, informal business structures such as sole proprietorships and general partnerships are best:
- They have to be extremely low-risk (low chance of liability or financial loss)
- They cater to a smaller number of extremely low-risk customers, who are frequently friends, family, and neighbors.
- They can begin as a hobby, such as painting, blogging, or video streaming.
However, there are no protective measures in these instances and each business owner is personally liable for anything that may occur with their business.
Informal Structures: Benefits and Disadvantages
The most significant advantage of forming a sole proprietorship or partnership is the ease with which one may get a business up and go.
Informal Corporate Structures Have Significant Disadvantages:
No Ability to Protect Personal Assets. Personal liability protection is not provided by informal company formations. This implies that if your company is sued or fails on a loan, your personal assets (vehicle, house, bank account) are in danger. Only extremely low-profit/low-risk businesses should be run in this manner.
No tax advantages. On their net profit, sole proprietors and partnerships pay self-employment taxes and income taxes. It will be exceedingly costly to tax a firm as an informal business structure if it becomes lucrative.
Growth Potential is Limited. A business’s success might be hampered by a high tax load and a lack of liability protection.
Credibility and Branding Protection Decreases. Unless the state enables them to establish and maintain a doing business as (DBA) name, a sole proprietor or partnership must invoice, accept payment, create a bank account, and sell using their surname(s).
Formal Corporate Structures: LLCs and Corporations
Formal corporate structures provide tax advantages, improved reputation, and — most significantly — protection from personal liability.
Formal corporate structures are divided into two categories:
Limited Liability Companies. A limited liability company (LLC) is a formal “pass-through” legal business structure owned by its members. An LLC is the most straightforward way to structure your company so that your personal assets are protected in the case of a loss. LLCs also have their own set of tax advantages and LLCs are easy to form and manage.
Corporations. Shareholders own a corporation, which is a formal legal corporate organization. Personal liability protection is provided by a corporation, which is more difficult to operate than an LLC as it requires more corporate formalities (accompanied by greater protection in many cases). When you need to attract outside investors, forming a corporation is really beneficial.
When Is It Appropriate to Use A Formal Business Structure?
For businesses with the following features, formal business forms such as LLCs and corporations are recommended:
- Increase customer base
- Profitability potential that is both immediate and long-term
- Increased responsibility or loss risk
- Would profit from one-of-a-kind tax provisions
When deciding on a business structure, personal liability protection is the most important issue to consider. Fortunately, determining whether or not you require it is rather straightforward. If your business faces liability or risk or uses business credit, you must have personal liability protection. The only drawbacks of having a formal legal organization are the costs and upkeep. These disadvantages are balanced by financial and legal benefits in a productive company.
Formal Business Structures Benefits
Protect Personal Assets. Personal liability protection is provided by formal company organizations such as LLCs and corporations. This implies that if your company is sued or fails on a loan, your personal assets (vehicle, house, bank account) are safeguarded.
Tax advantages. Formal company structures, such as LLCs and corporations, offer tax structure customization choices. This enables firms to employ the most effective tax plan for their specific circumstances.
Potential for expansion. Because they give personal liability protection and tax benefits, formal company entities such as LLCs and corporations can develop in profit and risk.
Consumer Trust and Credibility. In general, banks and customers trust LLCs and corporations more than informal company arrangements like sole proprietorships. This can damage a company’s ability to borrow money and its marketability.
Create a Limited Liability Company or Corporation.
You must conduct your business under a formal legal framework to protect your personal assets if you anticipate making a profit or if there is any possible danger. Creating an LLC can be as simple as filing Articles of Organization in your organizing state.
Choosing Between a Limited Liability Company and a Corporation
When compared to founding a corporation, most small businesses profit the most from incorporating a limited liability company (LLC). This is because companies are difficult to operate, and most small firms do not generate enough profit each year to justify paying hefty corporate taxes. A corporation, on the other hand, is the best option if your company will need to rely on outside investors.
When Should You Form an LLC?
The majority of small enterprises begin as limited liability corporations (LLCs). If you want to start a business, an LLC is probably the best option.
- You are not required to seek out investors.
- You intend to reinvest the majority of your profits into the company each year.
- An easy-to-maintain business structure would be most beneficial to you.
S Corporation Election and Pass-Through Taxation
It makes sense to create an LLC if you want to spend the majority of your profits back into your small business and don’t need to attract investors. Small firms typically carry relatively little earnings from year to year. This is because small firms frequently spend the majority of their earnings on costs that help them develop. LLCs can also choose to be taxed like S corporations. This option is for LLCs that make enough money to pay their owner’s fair compensation and make regular yearly payments of $10,000 or more.
The net income (profit minus costs) of the business is passed through to the LLC member(s)’ individual tax returns, which are known as pass-through taxes. This implies that the business will not be taxed, and you will only be taxed on the net income of the business. Both income tax and FICA taxes apply to distributions. The net income of a corporation is taxed once at the corporate level. If any of that profit is distributed to shareholders as dividends, the payout is subject to income tax and FICA taxes.
S Corporation Tax Option for LLCs
If you expect to generate a significant profit each year and don’t need to attract investors, an LLC that is taxed as an S corporation is the best option for you. LLCs are simple to form and manage.
Limited liability companies (LLCs) are straightforward company forms that involve less paperwork, have lower administrative costs, and are considerably easier to establish and operate than corporations. LLCs are also versatile, with the option to convert to corporations at any time. As a result, LLCs are a wonderful place to start if you want to expand your business.
When Is It Time to Form a Corporation?
Although the majority of small businesses begin as limited liability companies (LLCs), there are specific situations when starting as a corporation makes sense. A corporation structure would be beneficial to your small business if:
- You’ll need to entice venture capitalists and investors to your venture.
- You must roll over a considerable profit from one tax year to the next.
- Managing a complicated corporate structure has advantages.
Year-to-Year Profit Carryover
If a small firm is unable to spend a considerable portion of its profit on costs to develop the business within a tax year, it may be more advantageous to organize the company as a corporation rather than an LLC. This is because the two business entities are taxed differently.
All gains that a firm carries over to the next tax year are taxed at the current taxable rates. An LLC member’s tax burden would be higher in this situation since they pay FICA taxes as well as federal and state income taxes, which are higher than the current corporation rate.
However, a business owner who expects to carry profit into the next tax year should carefully consider the financial advantages of incorporating a corporation.
Investors and Venture Capital
Starting a corporation may be the best option for your small business if you need to attract investors. An investment in a corporation pays dividend taxes only when they get them, but an investor in an LLC must pay taxes whether or not they receive a payment. The LLC investor may never receive a return on their investment, but they will be required to pay taxes every year. This is why corporations are preferred by investors.
Managing a Complex Structure
Starting a corporation may make sense for your small business if the benefits of operating a sophisticated corporate structure exceed the expenses. Corporations are more complicated than LLCs, with more administration costs, more paperwork, and more complicated compliance requirements. Managing a company may need the assistance of an attorney or accountant, raising total business expenditures.
Contact our Corporate Attorney to choose the best corporate structure.
Different corporate structures have different laws controlling them, notably in areas like personal liability for business debts and tax requirements. A corporate attorney can assist you with the aforementioned key factors, so you can protect personal assets. Contact our corporate attorney today to discuss your options.