LLC the Right Type of Structure for my Business: If you’re thinking of starting a business, one of the most important decisions you’ll make is which business structure to use. A business structure is the legal format you choose to organize your business around.
There are many types of business structures, each with their own advantages and impacts, especially around taxes and liabilities.
One of the most common business structures is the Limited Liability Corporation or LLC. We’ll look at each of the main business structure types, including the LLC, to determine which is best for your business.
What to Ask When Determining Your Business Structure
There are many options to consider when thinking about the right business structure. Answering these key questions will help guide you in the right direction.
- Do you plan to run the company yourself or with other people?
- Are other people going to be equal partners in the business?
- Are the others going to be investors only or involved in operating the business?
- Do you expect to operate at a loss for several years?
- Do you plan to invest profits back into the business?
- Are any prospective owners non-U.S. based?
- Do you expect to raise money from investors right away?
- Do you plan to hold on to the company for at least five years before selling or going public?
- Do you plan to issue equity rewards to your employees?
- Do you want to protect your assets and those of other investors from personal liability?
- Do you want to manage a complex business structure?
- Do you want to avoid double taxation – where the business and shareholders are both taxed on the same income?
- Do you want the company to be a short-term venture, lifetime endeavor or last beyond your lifetime?
- Do you want to open the business informally or as a separate and distinct legal entity?
- Do you expect to be one of the chief operators of the company? At some point, do you foresee others operate the company while you move into an advisory role while maintaining an equity stake?
- Do you want the company’s board of directors to comprise original investors, outsiders or a mix of both?
- Do you want to be in control of the company while maintaining an equity stake?
While the questions may seem overwhelming at first, it helps to have answers clearly defined before you choose a business structure.
Let’s take a closer look at those most common business structures.
Informal Business Structures
There are two common informal business structures. It’s important to note that while these structures are simple to create and manage, they do not offer any taxation advantages or protection from personal liability.
A sole proprietorship is the simplest business structure. It typically involves one person who owns and operates their own business. If you plan to work completely alone, this structure may be best for you.
There is no formal organizational process for sole proprietors. A sole proprietor files their taxes under their own name. They are also fully personally liable for any adverse decisions against the business.
A general partnership is a business owned by more than one person but the business is not formally organized. The profits or losses from the partnership pass through the partnership, which is not taxed, to the individual partners. The partners include those profits or losses as part of their own tax returns.
Personal liability is the same for those in general partnerships as in sole proprietorships. The general partners are personally liable for the obligations and debts of and judgements against the company. Each general partner may make decisions or take out loans on the partnership’s behalf, too.
When to Use an Informal Structure
Informal business structures should be used when the ventures are very low risk of liability or financial loss. They are best with a smaller customer base and often begin as hobbies.
Advantages and Disadvantages
The main advantage of an informal business structure is the simplicity it provides. There’s no paperwork to file and it’s simple to launch.
The disadvantages are significant, however. Without liability protection, your personal assets, such as your house, cars, or savings, are vulnerable if you’re sued or cannot cover your debts.
From a tax perspective, you’ll need to pay self-employment and income taxes on any profits. The tax rates can also be significantly higher for informal businesses.
With an informal business structure, you’ll also find it difficult to secure financing and will need to handle things like involving, banking and marketing with your own name, unless your state allows for doing-business-as filings.
Corporate business structures are generally more formal organizational frameworks. They may carry certain requirements and provide favorable tax benefits. They also can protect you from being personally liable for judgements against the company.
A C corporation is an independent legal entity. It’s separate from its owners and requires compliance with additional regulations and tax obligations than simpler structures.
A C corporation is typically the choice for companies that are seeking venture capital funding and are looking to go public someday. The C corporation structure makes it easier to raise funds to support the business.
C corporations can sell stock, either common stock or preferred. Stock can be sold to founders, investors and employees. Preferred stock may be provided to owners, allowing them to be prioritized for receiving dividends over those holding common stock. There may be an unlimited number of shareholders.
Advantages and Disadvantages of a C Corporation
The biggest advantage to running a C corporation is the exclusion of personal liability. However, from a tax perspective a C corporation is not ideal. The business is taxed at the corporate tax rate at both the federal and state level, while shareholders are taxed on any income received from the corporation, typically in the form of dividends, on their personal income tax returns.
In addition, there are many regulatory obligations with a C corporation. There are persistent filings and fees to remain in compliance. The corporation must have a board of directors, an annual shareholders’ meetings, and diligent recordkeeping rules.
The S corporation is an option that acts in many ways like a C corporation but has considerable tax advantages.
An S corporation pays no corporate income tax. S corporations are also exempt from “double taxation” as the revenues are not taxed at the corporate level.
Instead, an S corporation is considered a pass-through taxation entity, much like a sole proprietorship or an LLC. The S corporation’s income passes through the business onto the business owners’ personal tax returns. In addition, owners without inventory can use the cash method of accounting, meaning income becomes taxable when received and expenses deducted when paid. The cash method is a simpler accounting process than the accrual method.
As an owner, you can also choose to have some of the business income paid to you as an employee salary and some as a distribution of income from the business. Such a structure may reduce your overall tax burden.
Advantages and Disadvantages of an S Corporation
In addition to the tax and liability benefits, S corporations are attractive to investors. That’s because S corporations can have up to 100 shareholders.
There are some downsides, however. They require similar filing and fee requirements as with a C corporation. They also must have a board of directors, hold director and shareholder meetings, keep detailed records, let shareholders vote on major decisions. S corporations can only issue one type of share and all shareholders must be U.S. citizens.
Limited Liability Corporations (LLCs)
LLCs are one of the most popular business structures. They require less administration, less paperwork and are easier to start and maintain. Owners are considered “members” and can act as single-member or multi-member entities.
Some describe an LLC as being the best of both worlds, given that its structure has elements of both corporations and partnerships. That’s one reason why it’s so attractive to small businesses.
From a risk standpoint, an LLC provides you with personal protection against the business’ liabilities.
The tax considerations provide some major advantages. As an LLC, for tax purposes, you can choose which classification you want. The classification you choose can help you optimize your tax position. The classification types are:
- Default or Disregarded Entity. This structure for a single-member LLC is simple and avoids double taxation. It’s ideal if the owner is looking to reinvest profits back into the business. The downside is that any money left over after reinvestment is taxed
- Partnership. This is the default classification for multi-member LLCs and is also a simple structure that avoids double taxation. However, it is not ideal for passive owners and investors
- S Corporation. This structure avoids double taxation and can have other tax advantages. The business pays no federal income tax but profits, after expenses and distributions, pass through to the owner. These profits are subject to income tax but not employment tax. Active business owners are considered employees
- C Corporation. This tax classification benefits shareholders the most. Active shareholders are classified as employees, meaning they can receive health care insurance and other benefits. However, LLCs with this classification are double taxed.
An LLC may only change its tax classification once every five year.
It’s also important to note that the requirements for starting an LLC differ from state to state, so make sure you know what’s needed in advance before you start the process.
Advantages and Disadvantages of an LLC
The tax flexibility and protection from personal liability are considerable advantages to choosing an LLC business structure. There can also be unlimited members and flexibility about you choose to run the business (no board of directors is required).
LLCs are subject to ongoing fees and filings to remain in compliance. In addition, an LLC cannot go public. In some foreign countries, the LLC designation is not recognized and you will be subject to taxes as a corporation.