Forming A Business: Sole Proprietorship, LLC, LLP, S Corp or C Corp?
Maybe you’re considering the idea of starting your own business, or perhaps you’ve already taken the plunge and chose a business name, set up a company website and clients are beginning to trickle in. But before you dive head first into the world of business ownership, you need to decide what kind of business entity to form – as forming a business is a key piece of the puzzle.
There are different structures you can choose from, including Sole Proprietorship, LLC, LLP, S Corp or C Corp.
Each business entity has its own advantages and disadvantages, and determines how you’ll be taxed, your personal liability if the business is sued, and how easy or complicated it will be to get your business set up legally.
Let’s go over what each type of business entity entails and the pros and cons of each one.
A sole proprietorship is when one person owns and runs a business on their own. If you have not yet formed an LLC or corporation, or have a business partner, then you are by default, a sole proprietor. No legal action needs to be taken to set up a sole proprietorship. For tax purposes, there is no division between you and your business. You just report your income or losses on your personal tax return. You can hire employees and contract workers, but you must remain the sole owner.
Sole Proprietorship PROS:
- It’s effortless and inexpensive to set up.
- You have full control and flexibility on how you choose to run and manage your business.
- All business profits are yours, except for the taxes you need to pay on that income.
- There is no separate tax filing for your business. You just use a Schedule C and Form 1040 with your personal tax return.
Sole Proprietorship CONS:
- You are personally liable for all business debts. Creditors can go after your personal assets, including your bank accounts and home.
- If a lawsuit arises against your company, your personal assets are at risk.
- Your entire income is subject to both self-employment tax and income taxes.
LIMITED LIABILITY CORPORATION (LLC)
A limited liability corporation, also known as an LLC, is similar to a sole proprietorship in many aspects, except that it also offers liability protection, which is very valuable. LLCs are relatively new and are becoming increasingly popular, mostly because if something with your business goes horribly wrong, your personal assets are guarded. LLCs must be filed with the state to be formed. Just like a sole proprietorship, the business income of an LLC is submitted as part of owner’s individual income, and not filed separately.
Limited Liability Corporation PROS:
- The process to form and maintain an LLC requires little paperwork and low fees.
- Owner’s personal assets are protected from liabilities which can arise from business debts or legal issues.
- LLCs do not file a separate tax return from the owner’s individual tax return.
Limited Liability Corporation CONS:
- If you are the single owner, 100% of your business income is subject to self-employment and income taxes.
- In addition to the annual fee you’ll need to pay to form the LLC, many states also require a yearly fee to keep your business open.
- As the owner, you cannot pay yourself a salary.
LIMITED LIABILITY PARTNERSHIP (LLP)
A limited liability partnership (LLP) is a business that must have two or more owners. LLPs are typical for professional groups such as doctors, lawyers, and accountants, where there are multiple partners. All owners have personal liability protection, but the level of limited liability varies from state to state. Some states only offer liability protection if the other partner was negligent; while other states also include liability protection from partnership contracts and business debts. Some states offer LLPs to professionals only.
Limited Liability Partnership PROS:
- All partners benefit from some level of liability protection.
- Each partner has a say in how the business is managed and ran.
Limited Liability Partnership CONS:
- A foreign LLP, which is an LLP formed in a different state, may not have the same liability limitations as the state it was initially established in.
- As some states limit LLPs to certain professions, an LLP formed in one state may not be recognized as an LLP in another state.
- Liability protection for LLPs may not be as comprehensive as LLCs and corporations.
S corporations are owned by shareholders, who report their business earnings on their individual tax returns, just like a sole proprietor would do. But shareholders also have the personal liability protection of a corporation, as long as all corporate formalities are followed.
A business can only be considered for S corp status if it has less than 100 shareholders, and all shareholders must be U.S. citizens or resident aliens.
An S corp must also process payroll, which means as the owner you receive a salary and what you take from your business profits are considered dividends. Therefore, you can bypass paying self-employment taxes, as the owner is deemed as separate from the corporation.
S Corp PROS:
- Owners have significant tax savings, as an S corp is a pass-through entity.
- Personal assets of shareholders and business liability are entirely separated, in case any issues arise.
- LLCs can request S corp status through the IRS, which means it would still legally be an LLC but would gain the tax benefits of an S corp.
- It’s easy to transfer business ownership of an S corp, in events such as retirement, the sale of the company, or death.
S Corp CONS:
- Forming an S corp can be a complicated legal process.
- S corps have tricky tax obligations, and if there are any errors when filing taxes, it can cause a business to lose its S corp status.
- S corps must process payroll, hold annual shareholder and director meetings and meet other requirements, while keeping and submitting thorough records of such.
C corporations are large, complicated business structures with strict formalities. The best way to remember the distinction between an S corp and a C corp is to associate C with “complex” or “costly.” C corps are considered a separate business entity from its owners, also known as shareholders. Unlike an S corp, C corps are subject to double taxation, as profits are taxed on the corporate level, and shareholders’ dividends are taxed again on the individual level. As long as all formalities of a C corp are followed, its shareholders’ personal assets are shielded from corporate liability.
C Corp PROS:
- If something terrible happens to the business, its shareholders’ personal assets are protected.
- C corps appeal to potential investors and employees because of its available stock options.
- C corps are well structured with clearly defined roles, agendas, and accountabilities.
- If the end goal is for the business is to go public on a stock exchange, forming a C corp is the preferred route.
C Corp CONS:
- C corps require a very costly and tedious setup process.
- C corps are a heavily taxed entity, as the business needs to pay corporate taxes and shareholders’ income is taxed again on their individual tax returns.
- Many regulations must be followed which allows for very little flexibility, including holding annual shareholder meetings, board of director meetings, and submitting recorded minutes of each.
VARIATIONS BY STATE
As taxes, costs and corporate laws vary from state to state, it’s best to consult with an accountant or tax advisor before ultimately deciding on which type of entity would be the best choice for your business.
Remember that no matter what state you’re forming a business in, or which entity type you choose, it’s important to always keep accurate records of all business expenses. Whether your business is a sole proprietorship, LLC, LLP, S corp or C corp, taxes will need to be paid.
Every business has expenses, and the majority of these expenses can be tax write-offs. These write-offs, also known as tax deductions, decrease your taxable income. Less income taxed results in lower taxes owed.
When tax time comes around, Everlance allows you to easily download data and reports, which can be handed over to your accountant or imported directly into any tax preparation software.
Everlance has a free plan which offers unlimited receipt uploads, 30 automated trips per month, and IRS compliant reports. For $5/month, you can get all those features and more through the Premium plan, including being able to sync your bank and credit card transactions. Everlance Teams offers integrated mileage and expense tracking solutions for your entire staff.
As a business owner, you have a lot on your plate. Let Everlance handle your expense and business mileage tracking so you can focus your time and effort on your company’s growth and success.