Starting a small business means reviewing entity formation options and choosing the right entity to structure your business. Here are some of the most popular business structures and what you need to know about choosing a standard or expedited incorporation filing.
A sole proprietor is not a legal entity formation. According to the IRS, a sole proprietor is someone who owns an unincorporated business.
Typically, the owner who elects a sole proprietorship formation does so for a few reasons. First, it’s the most affordable option. There is little paperwork involved and minimal expenses for setting up a sole proprietorship. Sole proprietorships allow the owner of the business to be the boss. They get to exercise full control over all business decisions and assume responsibility for everything impacting the business, including personal liability for business debts and paying a significant amount of business taxes.
Sole proprietorships are also ideal for low-risk businesses. If you are starting a very small business, such as a hobby you enjoy like writing, and know there is limited growth potential in the business, you may begin as a sole proprietorship. However, once your hobby starts to grow its customer base, earn a profit and report income, the small business will be engaging in business activity and needs to look into incorporating as a legal business structure.
Limited Liability Company (LLC)
Most small businesses interested in incorporating will choose to form a limited liability company (LLC) or corporation. LLCs are quite popular due to the entity’s flexible structure and the limited liability protection it provides small businesses.
Limited liability protection creates a separation between the owner’s personal assets and professional assets. This means your personal belongings, like homes and cars, are not impacted in the event of an unforeseen circumstance that negatively affects the business such as the business being served with a lawsuit.
The owner of an LLC, also referred to as a member, may pick a flexible management structure in which they run the LLC. Depending on the number of members who own an LLC and their needs, this structure may be a single member LLC, member-managed LLC or manager-managed LLC.
You may also choose the way you would like to tax an LLC. LLCs are considered a pass-through entity, meaning profits “pass through” to members and are reported on individual tax returns instead of at the business level. LLCs, taxed as a partnership on the federal level, often elect to be taxed as another entity. The most popular choice for LLCs is to elect to be taxed as an S Corporation. An S Corp also has a pass-through entity status, allowing LLCs to be taxed as a pass-through entity.
Forming a corporation means you have big plans for your startup. At some point, you’d like to expand the business on an international level, offer an IPO and go public with the company. A corporation will allow you to reach these big plans for your business.
Of the three entities, corporations are the most structured formations. It is similar to an LLC in providing its owners with limited liability protection, but they are not nearly as flexible as an LLC. Corporations require the observation of certain formalities. This includes annual meetings with minutes taken during said meetings, establishing corporate bylaws outlining the corporation’s rules and regulations and appointing shareholders and directors for the purposes of long-term management. You may also issue shares of stock and sell percentages of the business to the corporation’s owners, or shareholders.
What about taxes? Corporations are subject to double taxation. This means the income is taxed first at the corporate level and again at a personal level when it’s distributed to members as dividends. Similar to an LLC, however, corporations may elect an S Corporation designation to avoid double taxation.
Which Structure Is Right for My Business?
Once you have an overview of the three most popular business structures, take a look at your business. Review its short- and long-term goals and plans and determine if one of these structures is the best fit for its needs.
If you are still uncertain or interested in exploring another business structure not listed, such as a nonprofit corporation or partnership, reach out to a trusted legal professional for additional advice and guidance.
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