Choosing between running your business as a sole proprietorship, an LLC, or a corporation can be confusing and there isn’t necessarily a right answer. It really just depends on what your goals are: limiting liability, receiving major investments, making tax payments simple, etc., and then choosing the structure that best meets your needs.
So, let’s talk about the 3 most popular choices you should consider when choosing the right entity for your business.
By definition a sole proprietorship has only one owner. If you haven’t formed an official business yet and you’re running one anyway, you have a sole proprietorship. They are easy to start, you literally just start doing business.
There are none! Legally there is no difference between you as a person and your business, therefore, you are 100% responsible for all of the legal claims and debts that arise in your business. That means that if somebody gets hurt using your product or walking into your store, you personally have to pay. Also, if you use suppliers or vendors to run your business, you are personally responsible for paying the bill even if the business runs out of money.
You already know what happens when somebody owes a debt. The creditor can come after your personal assets such as your house, personal bank accounts, your car, or any other personal asset that court decides to use to satisfy the balance owed to the creditor.
When it’s time to pay taxes, sole proprietors report business income on an IRS Schedule C which is filed with the 1040 individual tax return. This is called “pass-though” taxation because the business tax liability is passed through to the individual owner and the owner’s profits are taxed at his or her individual tax rate.
Most business owners starting out benefit from pass-through taxation because it is much simpler to keep up with than preparing corporate tax returns. Also, since sole proprietors are self-employed, they do not have to pay Social Security or Medicare taxes and eliminate payroll fees and deductions.
Limited liability companies (LLCs) are the best of both the sole proprietorship world and the corporation world. As the name suggests, LLCs limit the owner’s personal liability for lawsuits and business debts, but also allow business owners to pay taxes on their individual income tax returns.
So, a limited liability company limits personal liability for business debts (like a corporation) and provides pass-through taxation for business taxes (like a sole proprietorship).
An LLC can have one owner or many owners. Also, the owners can be individuals or other business entities and can live in state, out of state, or even abroad.
With just one owner, reporting LLC profits on the Schedule C is no big deal and usually pretty simple. Where things get more complicated is when there are multiple owners. Individual tax liability will be apportioned according to what is stated in the business’ operating agreement.
My suggestion is to meet with an accountant as soon as the business begins so that the individual tax obligations can be explained thoroughly. Make sure your accountant is local and aware of all of the tax benefits, write offs, and obligations applicable to your business in your state.
There are two options for managing an LLC. The first is to run it as a member-managed LLC and the other is to have a manager-managed LLC. In a member-managed LLC the business is “managed” or run by all of the owners. In a manager-managed LLC the members can elect a member or an outsider to manage and run the business. Most small LLCs are member-managed and the other management style is used when one owner wants to assume full control of the LLC while the other owners act as passive investors.
A corporation is a legal entity that is completely separate from any other person or entity for legal and tax purposes. Since state and federal laws view corporations as a legal “person,” corporations can enter into their own contracts, incur their own debts, and pay their own taxes, separate and apart from the owners.
Generally speaking, a corporation can have an unlimited number of shareholders or owners. There are some regulations for who can be an owner for professional corporations, so it is important to investigate those rules before forming the business.
What is also notable about corporations is that they must have directors and officers to run and manage the business. In a single-shareholder corporation one person can be the director, president, secretary, and treasurer or those positions can be filled by multiple people.
Corporations are subject to their own tax rules and regulations and are responsible for paying their own taxes. That means that the individual shareholders are not responsible for paying the corporation’s taxes. If, however, the owners want to take advantage of pass-through taxation, they can elect to have the entity taxed as an S Corporation and the individual owners/shareholders will pay taxes on the profits that pass though to them.
In my opinion, you should talk to both an attorney and an accountant to help you decide which business structure is best for your business. Although there is no “right” or “wrong” answer, there are some important things to consider before making a final decision and it will not hurt to ask an expert for their opinion.
Feel free to schedule a time to talk with me using the link below!