Avery important decision any business owner must make is which structure is the best for the company. The options can be anything from a basic sole proprietorship to the C corporation structure used by large corporations. The form you select dictates crucial issues, such as legal liability, tax treatment and the ownership structure for your business. “It’s certainly as important as the nature of your business and the way that you operate,” says Eric Siegel, president of Siegel Management Co., a business consulting firm in Bryn Mawr, Penn. “It’s easy to do this fast and wrong.” He and others recommend you consult an attorney, an accountant or both. “In working with those advisers, you need to know what your objectives are with the company, your plans for operations and perhaps more
important your plans for capitalizing the company,” Siegel says. “It’s not one-size-fits-all, but it’s not brain surgery either.”
Below is a summary of the most common business structure an analysis of their use and benefits.
If you are working for yourself and no one else has any ownership interest, this is the easiest and most basic form to operate a business. For tax and legal purposes you are an individual. Any income (hopefully) you receive is
reported on Schedule C of the individual 1040 tax return. Be careful, the business owner will have to pay self employment tax for Social Security and Medicare.
- Potential users: Freelance businesses such as consultants and journalists and many home based businesses
- Advantages: Very simple, the least expensive business structure with only one tax return
- Disadvantages: Self-employment tax (15.3 percent), no limit on legal liability. This tax totals 15.3 percent (twice the rate you’d pay if you were working for a company).
In essence, your are both the employer and the employee so you have to pay the Social Security and Medicare withholding that normally an employer would make. This only applies to your first $102,000 of adjusted income. You can deduct one-half of the self-employment tax money you owe from the total amount that’s subject to your normal income tax. You are personally liable for all the debts of the business. “That can include everything from your electricity bills to someone coming into your store, falling and then suing,” says Richard Rampell, chief executive of Rampell & Rampell accounting firm in Palm Beach, Fla. For someone providing a simple service from the home, such as a business consultant or a freelance writer for example, this maybe the best structure. If you don’t expect
lawsuits, remaining a sole proprietor saves on the legal and accounting expenses of a formal company.
Tony Decello, a financial adviser at Deloitte Tax in Cleveland, says many of his clients initially favor a corporate or limited liability company, or LLC, structure to shield themselves from liability. But doing so doesn’t make sense for an individual, “unless you’re making significant money to justify two sets of books and two bank accounts,” says Decello, who has represented top golfers and tennis players. And even as part of a corporation or LLC, an employee is personally liable for his/her own actions. “People will sue the entity and you,” he points out. “It’s often
cheaper just to buy commercial liability insurance.”
Even if you decide to become a sole proprietor, the owner can still give your business a name that will sound more professional. Depending on the state, you can register the business as a DBA (doing business as). In any event, it strongly suggested the business owner open a separate business account whether using a DBA or not. There are several reasons to do this. The first that even though the owner and the business are indistinguishable for tax and legal liability, it is best to separate your personal bills from your business bills and income. This will also give the owner a better handle on the activity of the business. If it is necessary to prepare profit and loss
statement for your business, having a separate business bank account will make it much easier. In addition, if the business owner wants or needs a business loan to expand, a commercial lender will want to see business bank statements. This allows the owner to be more efficient and organized.
Limited Liability Company, or LLC
The whole purpose of this type of structure is, obviously, to limit the liability of the owner. Another benefit is that you can avoid the double taxation that comes with a C corporation. Under that structure, the corporation pays its own income tax, and then shareholders are taxed when they receive dividends. Having an LLC allows the members
to choose to have income passed through to the company’s owners. The company itself pays no income tax, but the members are subject to self-employment taxes. The LLC can have any number of members. In addition, as in contrast to the S corporation, which has to distribute dividends in proportion to number of shares held, LLCs can distribute profits however they choose. “You have a lot more flexibility using an LLC than other structures,” says Saul Brenner, a partner at New York City accounting firm Berdon LLP.
Limited Liability Company, or LLC summary:
- Potential users: Any business that doesn’t need to go public or attract venture capital quickly.
- Advantages: Flexibility in ownership and dividend payment structures, limited legal liability, no double taxation.
- Disadvantages: Self-employment tax, no tax deduction for dividends, uncertain legal environment compared to a
“You have the advantage of limited liability that you get through corporations, but a lot more flexibility as to allocation of income. You can get different people involved as equity owners with different classes of membership. It’s far superior.”
S corporations aren’t subject to double taxation and has limited liability. Employees aren’t subject to self-employment taxes. Many businesses that are operated by a single person will use this structure. Here are some
things to keep in mind:
- Potential users: Businesses that want the legal certainty of a corporate structure, but the tax treatment of an LLC.
- Advantages: Limited liability, no double taxation, no self-employment tax.
- Disadvantages: Inflexible ownership structure, profits and losses must be allocated in proportion to ownership shares, you can’t have corporate or foreign owners. Of course this is not a problem if you are the sole owner.
Be careful about pushing out all your income as dividends to avoid having to pay Social Security taxes. It is possible that if the IRS sees you didn’t take anything for income to pay salaries and didn’t pay Social Security taxes, it can make you reclassify some of your income as salaries.It is important to note that an S corporation is limited to 100 shareholders and one class of stock. If you have a business for which you need a lot of investors, this may pose a problem.
This is the most common structure among larger companies. “It’s the favorite form for startups looking for eventual venture capital investors or a public offering,” Rampell says. That’s because of its simplicity. But he and others caution against blindly adopting this structure. For example, a startup that suffers losses during its first two years would do better as an LLC, Rampell points out. That’s because LLC members will be able to write off the losses on their personal taxes. “In a C corporation developing-year losses get wasted until you make a profit,” he explains. “And in an S corporation you can only deduct the money you’ve invested or directly loaned to the company.”
Items to consider in using a C corporation:
- Potential users: Businesses that want to go public or obtain venture capital investments.
- Advantages: Limited liability, flexible ownership structure, tax deduction for dividends, no self-employment tax.
- Disadvantages: Expensive to establish and maintain, double taxation.
Some C corporations try to avoid the double taxation problem by giving out all their profits in compensation. But that’s not a wise strategy. “You get into issues of unreasonable compensation,” Brenner says. “The IRS can say your compensation is too high and that some of it is disguised dividends.”