Choosing the appropriate business structure is a pivotal decision that holds significant implications for your enterprise, encompassing tax obligations, vulnerability to risk, and even the feasibility of securing a business loan. In this regard, it is imperative to assess the advantages and disadvantages associated with the foremost four methods of structuring your small business.
Sole Proprietorship
The sole proprietorship business model is highly favored in the United States, where a majority of small businesses, precisely 73 percent, are operated by a sole proprietor. This unincorporated business model is straightforward to establish and operate, requiring no legal action to form.
The ease of organization is one of the key benefits of a sole proprietorship, as it only requires the necessary licenses and permits. If conducting business under a name other than one’s own, a “Doing Business Name” filing may also be necessary at the city or county level. Tax preparation is also simplified, with all business income and expenses reported on the personal tax return.
However, a significant drawback of this structure is the lack of liability protection. The lack of a legal separation between the proprietor and the business signifies that the proprietor can be held liable for any debts or legal actions brought against the business. This is a crucial reason why many businesses choose to incorporate.
Additionally, sole proprietors may face credibility issues, as clients may not view the business as professional or dependable without incorporation. Incorporation is also necessary when seeking a business loan.
Given the absence of legal protections, sole proprietors often operate in low-risk industries and may be freelancers, independent contractors, home-based businesses, or offer professional services.
Limited Liability Company (LLC)
When looking to grow your business, attract external investment, or enhance liability protection, it is recommended to contemplate organizing your business as a Limited Liability Company (LLC). To establish an LLC, it is necessary to submit articles of organization to the relevant state authority, usually the secretary of state. In the instance of a multi-member LLC, such as a business partnership, it is also advisable to formulate an operating agreement to guarantee that every member comprehends their obligations for the smooth operation of the business.
One of the key advantages of an LLC is that it shields business owners from personal liability for any debts or obligations incurred by the business. In the event of a lawsuit, only the assets of the company are at risk, safeguarding personal assets.
LLCs, like sole proprietorships or partnerships, pass taxes through the business to each member of the LLC.
It is crucial to emphasize that the protection offered by an LLC is “limited.” The LLC status does not provide immunity against all legal actions, such as violations of intellectual property laws or lawsuits from employees. Therefore, it is essential to obtain business insurance to mitigate potential damages to the business.
Business Partnership
A business partnership, in its simplest form, denotes an unincorporated business that is collectively owned by multiple individuals. The profits earned by the partnership are divided among the partners and are disclosed on each partner’s personal income tax return through the pass-through approach. Furthermore, the partnership must submit an informational return to the IRS, detailing its gains and losses.
There are several advantages to forming a partnership. They are relatively easy to establish and maintain. It is highly recommended to create a partnership agreement, similar to a prenuptial agreement, to officially outline the responsibilities and obligations of each partner, the distribution of profits, the process for resolving conflicts, and the protocols for ending the partnership. It is advisable to seek legal assistance to ensure the partnership agreement is comprehensive and legally binding.
On the other hand, it is important to note that a basic partnership does not provide protection for the personal assets of the partners in the event that the business faces legal claims or demands for payment. This lack of personal liability protection may be a concern for individuals in high-risk professions such as law, healthcare, or certain types of general contracting. In such cases, it may be more appropriate to consider forming a limited liability company (LLC) to provide additional protection.
S Corporation
The S corporation, commonly referred to as an S corp, has gained popularity due to its potential tax benefits. To establish an S corp, it is necessary to first incorporate as a limited liability company (LLC) and then file a special election with the Internal Revenue Service (IRS) to have the LLC taxed as an S corp. While retaining the legal benefits of an LLC, the S corp structure offers distinct tax advantages.
One of the primary benefits of an S corp is that business owners can draw a salary from the company’s profits as an employee. This approach can be advantageous from a tax perspective, as only the wages received are subject to self-employment tax, which is currently 15.3 percent of income.
When all expenses have been accounted for, the residual profits can be allocated to the owner or owners as dividends. These dividends are subject to the standard personal income tax, but the noteworthy aspect is that they are taxed at a lower rate than regular income. This has the potential to lower the total tax liability for the year.
However, it is important to note that starting and operating an S corp can be complex and more expensive than other options. It is highly advisable to seek guidance from a tax consultant in order to assess the pros and cons of this framework for your business.
Overall, it is crucial for individuals considering starting a business to carefully evaluate their specific needs and circumstances, and to seek professional advice to determine the most appropriate legal structure for their business.
Reach out to Profit Wise Accounting to learn more about how we can assist your business with Corporate Structures.
Call us at (256)-489-1478 to schedule an appointment or schedule a consultation here.
