One of the key decisions in starting a business is deciding which business type to form. You'll get lots of advice from people, but as you sort through it, consider taxation, control, cost, and liability issues.
This article will unpack features, along with pros and cons, of each of the major business types to help you make the best decision for your new business.
- The two basic business types for tax purposes are corporations that are separate from owners and pass-through businesses that file their business taxes with their personal tax returns.
- Cost of startup and operations, control, taxes, and liability issues are important factors to consider in choosing a business type.
- The tax situation of a business includes federal and state income taxes and whether the owner must pay Social Security and Medicare taxes.
- Corporations and partnerships come in different types, and there are special types for groups of professionals.
- The choice of a business type is complex and can be costly, so it's important to get help from an attorney and tax professional
Factors to Consider in Selecting a Business Type
As you start your business or consider changing your business type, consider these four important factors during your decision-making process:
- Cost and complexity of running the business, including legal fees and cost of operation
- Ownership control and the tradeoff between control and profits/losses
- Taxes on the business and how the business or owner pays taxes
- Liability of business owners for the debt of the business, for actions of other owners, and for general liability
Basic Types of Business Organizations
Since taxes are a major issue in deciding which business to choose, here's an explanation of the two basic business types for income tax purposes.
A corporation is a business that is separate from its owners, called shareholders, who buy shares of stock in the corporation. These owners receive payments from the business in the form of taxable dividends. Some owners might also be executives or employees, and they're paid as employees for the duties they perform in addition to receiving shareholder dividends.
Pass-through businesses are named as such because the tax liability of the business is passed through to the owner as part of the owner's personal tax return. For example, if a sole proprietor has a net income of $25,000 for the year on their Schedule C, that amount is added to all the other income of the person (and their spouse, if they have one), along with any business and personal tax credits, to calculate the person's total tax liability for the year.
Sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations (a special kind of corporation) are considered pass-through entities.
S corporation owners are not considered as being self-employed. You should include self-employment taxes when you look at your tax situation for one of these business types.
Business Types in States
Corporations, partnerships, and limited liability companies (LLCs) must register with a specific state where they plan to do business. Requirements and rules for business structures are set by the states through each state's business division or corporations office. All states allow corporations, partnerships, and LLC's, but some variations on these basic business types might or might not be available in all states.
Check with your secretary of state's office, usually the business division, to get more information on their registration process.
Sole Proprietorships (Sole Props)
A sole proprietorship is a type of business operated by one individual. The business is not considered a separate legal entity from its owner and it doesn't have to register with a state. This feature has pros and cons.
On the pro side, the sole proprietor has full ownership rights in decision-making and doesn't have to answer to a board of directors or other owners. It also means the owner receives all the profits of the business. Taxes are fairly simple, consisting of a Schedule C form included in the owner's personal tax return.
On the con side, it means the owner must take all of the losses of the business. It also means that the owner may be personally liable for the debt of the business, in bankruptcy, for lawsuits against the business, and for general liability purposes.
Sole proprietorships might be a good choice or starting a new business in a low-risk situation before forming a more formal business.
Corporations (C Corps)
An incorporated business is separate from its owners for operations, taxes, and liability purposes. The corporation is formed with articles of incorporation under the laws of the state in which it operates. Corporations are costly to form because, in addition to the state registration, they must have a board of directors, keep regular meeting minutes and other corporate records, and report to shareholders.
Two benefits to incorporating are the generally low corporate tax rates and the ease of raising funds from investors.
Professional Corporations (PCs) and Professional Service Corporations (PSCs)
Two types of corporations are designed specifically for professionals in practice with other professionals.
A professional corporation is a specific type of corporation for licensed professionals such as attorneys, doctors, architects, or accountants. These professionals can form a corporation in some states with the liability protection of a corporation. But in this business type, each professional is still liable for their own wrongful professional actions.
A personal service corporation (PSC), meanwhile, is limited to providing personal services. To qualify for this status, the PSC must meet certain IRS requirements including shares of stock owned and amount of services performed by owner-employees. A wide range of professional fields can qualify as a PSC.
S Corporations (S Corps)
A subchapter S corporation or S corp is a corporation which has the limited liability benefits of a corporation but is taxed as a pass-through business, like a partnership. The S corporation owners aren't double-taxed on their income, but there are several restrictions on electing S corporation status, including a limit of 100 shareholders and only one class of stock.
Taxes are fairly complex for S corporations because they must file a federal tax return return, have separate schedules for the tax due from owners, and some states also tax S corporations.
Like corporations, though, S corporations must have a board of directors and follow all the filing and operating procedures of a corporation.
An S corporation is not set up by registering with a state. You must first set up a corporation in your state then you can elect S corporation status with the Internal Revenue Service (IRS). This election must be done within a specific time period so check with a tax professional to make sure the election is done correctly.
Limited Liability Companies (LLCs)
All states allow the formation of an LLC by registering articles of organization or a similar document with the state and creating an operating agreement to govern member decisions, including how they share profits and losses of the business. LLC owners are called members, and an LLC may have only one member, called a "single-member LLC."
LLCs are easier to form than corporations, but they have similar protection against liabilities of the company as corporations have.
Another benefit to forming an LLC is that there are several options for taxes, which can depend on specific situations as outlined below:
- A single-member LLC pays taxes on its personal tax returns (using Schedule C as a sole proprietorship).
- A multiple-member LLC usually pays taxes like a partnership.
- And both types of LLCs can elect to be taxed like a corporation or an S corporation.
A partnership is a business with two or more individuals who share the risks and benefits of the business, including the partnership profits and losses. Partnerships are fairly easy to start and operate. They must register with a state and create a partnership agreement. They have some recordkeeping requirements, but ones that are not as complicated as those of a corporation.
A partnership may include two types of partners:
- General partners who participate in the day-to-day management of the business and have liability for partnership debts and for actions of the partnership
- Limited partners who are merely investors and don't share in the day-to-day operations of the business or in liability
Partnerships pay their business taxes by filing an information return with the IRS to report business tax liability. No tax is paid on this form because of the partners' pass-through status. Instead, the income or loss is divided between the partners according to their agreement. Then, each partner receives a Schedule K-1 form showing their share for the year, which is reported on their personal tax returns.
There are several types of partnerships to choose from depending on the amount of liability the partners want to assume and the type of group working in the business:
A general partnership includes general partners who each make business decisions, but each partner has unlimited liability for debts and decisions of other partners.
A limited partnership (sometimes called an "LP") has both general partners who participate in business decisions and limited partners who invest in the business but don't participate in daily operations. General partners have liability for company debts and actions, but limited partners are shielded from liability as long as they don't become involved with business decision making.
Limited liability partnerships (LLPs) are formed with general partners but all the general partners are shielded from liability for the acts of the others as well as employees. The LLP is similar to an LLC but operates under partnership rules.
Businesses with multiple owners or groups of professionals, like a law firm or CPA firm, often use one of the partnership types depending on their specific situation.
Limited liability partnerships are not allowed in some states, and they may be limited to certain types of professions, such as doctors, attorneys, and accounting firms. Check with your state if you are considering this type.
Frequently Asked Questions (FAQs)
Do I need an attorney to start a business?
You may not need an attorney to start a sole proprietorship because you don't have to register the business or create a contract with other owners. For other business types, get help from both an attorney and a tax professional. The attorney can help you prepare and file important documents and consider your liability, and the tax professional can help you analyze your tax situation.
Which type of business is the most common?
Sole proprietorships are the most common type of business in the U.S. A survey by the Tax Foundation found that there were 23 million sole proprietorships operating in 2014, compared to 1.7 million C corporations and 7.4 million partnerships and S corporations.
Which type of business has the least personal liability?
Here's a general ranking of liability for their owners of the major business types discussed in this article:
- Corporations have the least liability because they are completely separate from their owners.
- LLC owners and S corporation owners have limited liability in essentially the same way as a corporation.
- Limited partners in a partnership also have limited liability because they are merely investors, but general partners don't have limited liability because they participate in the business.
- Sole proprietors have full liability because the owner and their business are tied together for tax and legal purposes.