The Pros and Cons of Each Business Structure
It's a critical decision that can have a big impact on your business, including how much tax you pay, your risk exposure and even your ability to get a business loan.
Let's look at the pros and cons of the top four ways to structure your small business.
Sole Proprietorship
A sole proprietorship is the most popular business structure in the US — 73 percent of small businesses are run by a sole proprietor. It's an unincorporated business that requires no legal action to form, making it the simplest structure to organize and operate.
Pros: All you need are the necessary licenses and permits. If you want to do business using a name other than your own, you may also need to file a "Doing Business Name" with your city or county. That's it!
Tax preparation is also simplified. Without any legal separation between you and your business, you simply report all your business income and expenses on your personal tax return (known as "pass-through" taxation).
Cons: The lack of liability protection is one concern. Because there is no legal separation between you and your business, you can be held liable for any debts or legal action brought against your business. This is a major reason why businesses incorporate.
Sole proprietors can also struggle with credibility issues. By not incorporating, clients may not view your business as professional or dependable. Incorporation is also a must if you're seeking a business loan.
Since a sole proprietorship doesn't afford any legal protections, sole proprietors often operate in low-risk industries and can be freelancers, independent contractors, home-based businesses or offer other professional services.
Limited Liability Company (LLC)
Generally, if you're growing your business, seeking outside investment or want more liability protection, consider structuring your business as an LLC. To start an LLC you'll need to file articles of organization with your state, usually the secretary of state. If you have a multimember LLC, such as a business partnership, it's also a good idea to create an operating agreement so each member is aware of their responsibilities for the smooth operation of the business.Pros: An LLC provides business owners protection from any personal liability for business debts and obligations. If your company is sued, only the company's assets are at risk, not your own.
Just like the sole proprietor or partnership, taxes in an LLC are passed through the business to each member of the LLC.
Cons: It's important to stress that the protection is "limited." The LLC status won't protect you from all actions such as breaking intellectual property laws or being sued by an employee — that's why it's important to have business insurance to protect you against business damages.
Business Partnership
In its simplest form, a business partnership is an unincorporated business owned by multiple people. Profits are divided up among the partners and reported, through the pass-through method, on each partner's personal income tax return. In addition, the business will need to file an informational return reporting the partnership's gains and losses to the IRS.Pros: Partnerships are easy to start and maintain; however, it's strongly advised that you set up a partnership agreement to formalize who does what, how profits are split, how you'll handle disagreements and steps for dissolving the partnership. You'd be well-advised to work with a lawyer to ensure the agreement is watertight.
Cons: What works for some may not work for others because a basic partnership doesn't protect its owners' personal assets against anyone who demands payment from the business. High-risk professions (law, healthcare, some general contractors) may need more protection. For this, consider forming an LLC.
Other options available to partners include a limited liability partnership (where multiple partners enjoy limited personal liability for debts and obligations). Or, if you have a silent partner (one that provides funding but no management direction), consider a limited partnership in which the managing partner has unlimited personal liability while the other partner has limited liability.
S Corporation
An S corporation (or S corp) is becoming a popular choice because of the tax benefits it can bring.
To become an S corp you'll need to incorporate as an LLC. Then make a special election with the IRS to have your LLC taxed as an S corp. From a legal standpoint, you retain the same benefits of an LLC, but for tax purposes you're treated differently.
Pros: In an S-corp arrangement, the business owner draws a salary from the business's profits as an employee. From a tax perspective, this can be good news, since only your wages are subject to self-employment tax (currently 15.3 percent of your income). The remaining profits are distributed to the owner or among the owners as dividends on which you pay regular personal income tax. Dividends are taxed at a lower rate than income, which could potentially reduce your annual tax liability.
Cons: Starting and running an S corp is complicated and a little more costly than other options. If you want to go this route, talk to a tax adviser to assess the pros and cons for your business.
For more information about choosing a business structure, check out SBA's guide to Choosing a Business Structure.