Choosing the best business structure for your small business is one of the most important decisions you will make. The decision will affect you legally and financially. Every business is different, but here are some general things to keep in mind when choosing a structure for your small business. We compare LLCs vs. S corporations vs. C Corporations, partnerships, and sole proprietorships.
If you’re still in the planning stages, however, you have a general question on how incorporating works, we suggest using the free “Ask A Question” service from Avvo. Typically, a lawyer will provide an answer back within 12 hours.
LLC vs. S Corp. vs. C Corp. vs. Partnerships vs. Sole Proprietorship Comparison Table
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*There is a third type of partnership called Limited Liability Partnership. In this type of business, partners are shielded from the negligent acts of other partners. We do not include LLPs in our guide because not all states recognize this type of partnership and of those that do, some limit LLPs to professional services firms such as accounting and medical firms.
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Best Business Structure Overview
Start your business on solid footing by choosing the right business structure. There are six main options are available for you to compare: Limited liability company (LLC) vs. C corporation vs. S corporation, general partnership, limited partnership, and sole proprietorship.
Some of these options, like corporations, have been around for a long time. Others, such as LLCs, are relatively new but very popular among small businesses. In fact, the number of new LLCs now outpaces new corporations by a margin of almost two to one. While every business is different, each structure is well suited for certain types of businesses:
Which Types of Business Is It Right For?
Low liability businesses, such as retail; one-person online businesses, such as Etsy and Amazon shops; freelancers; small businesses that are just a hobby or part-time job for the owner.
Same types of businesses as sole proprietorships but with multiple owners.
Tech startups that want to go public in the future; businesses that raise a lot of money from outside investors; businesses, such as construction or healthcare companies, where liability is a concern.
Small businesses that need liability protections, don’t need to raise a lot of money from investors, and want more flexibility in how the business is managed and taxed.
Keep in mind that the structure you choose for your business today may not be right for it a few years from now. Many businesses start out as sole proprietorships or partnerships and mature into LLCs or corporations as they grow. On the other hand, some businesses are serious undertakings from the get go, and owners are willing to put in the time and expense to form a corporation or LLC at the start. That’s why it’s important to compare LLCs vs. S corps vs. C corps. and figure out which one is best for your business.
Setup Process and Cost
The amount of time and resources needed to set up your business depends on the business structure you choose. For instance, most people can start a sole proprietorship or general partnership on their own relatively quickly, but you will probably want to consult an attorney if you’re forming a corporation.
Sole Proprietorship – A sole proprietorship is the easiest and least expensive way for one person to start a business. If you are providing a product or service to the public, do not have business partners, and have not setup any other legal entity for the business, then you are automatically a sole proprietorship. All you need to do is get local licenses for your type of business (e.g. restaurant or construction permits, zoning or selling permits, etc.) and register your trade name (i.e. Bill’s Auto Shop) with the county clerk if you’re going to do business under a name other than your legal name. You can find more information on trade names here. Registering a trade name costs around $100 in most states; the cost of local licenses varies pretty widely.
General Partnership – A general partnership is similar to a sole proprietorship but with two or more partners running the business together. It’s also very easy to start–if two people verbally agree to form a business together, you have a general partnership. As with a sole proprietorship, you need to get local licenses and register your trade name (if applicable). We recommend that you take one extra step and formalize your partnership with a written partnership agreement to outline how the business will be run. While this isn’t legally required, many businesses fall apart because of disputes among partners, and a written partnership agreement helps you avoid that. You can hire an attorney to draft a partnership agreement, which will cost around $500 to $2000 depending on its complexity. For a simple low-cost partnership agreement, you can use a template from LegalZoom for just around $15.
Limited Partnership – The key difference between a limited partnership and a general partnership is that the former has a special class of partners called limited partners. Limited partners invest in the business but do not run or manage it. It’s even more important to have a partnership agreement with a limited partnership to distinguish the rights of general and limited partners. To form a limited partnership, in addition to obtaining local licenses and registering a trade name (if applicable), a general partner must file a Certificate of Limited Partnership with the state. This costs around $100 to $200 depending on which state you’re forming the business in. You must also publish notice of the limited partnership’s formation in a local newspaper.
Corporations – The corporation is the most expensive and difficult business structure to form. We recommend hiring an attorney to help you customize corporate documents for your business needs. In most states, you must file Articles of Incorporation (costs around $100-200), create bylaws and organizational resolutions that specify the operating rules for the corporation, appoint a board of directors, and issue stock certificates to your initial shareholders. This last step can be complicated because stock certificates must comply with federal securities laws. Some attorneys recommend having a founders’ agreement (similar to a partnership agreement) to prevent disputes among business owners. In addition, you must register a trade name (if applicable) and obtain local permits as you would need to do with any business form. Almost all states allow one-person corporations, where the business owner serves as officer, director, and shareholder.
LLCs – In the last decade, many small businesses have chosen to structure themselves as LLCs. An LLC is a bit easier to form than a corporation, but the state filing fees are usually about the same. You must file articles of organization with your state and publish notice of the LLC’s formation in a local newspaper. As with any business form, you must obtain local permits and register a trade name (if applicable). Only New York requires an operating agreement, but we recommend that you have one in writing no matter where you form your business. It serves a similar purpose as a partnership agreement and outlines how the LLC will be run. All states now allow single-member LLCs, so a one-person business can form an LLC.
Getting The Best Deal
There are a number of companies that offer incorporation services with different pricing options and service levels. Here are some of the most popular options:
LegalZoom – The market leader in terms of size and Fit Small Business’ recommended provider of online legal services. They will tend to be a little more expensive than the other options.
Rocket Lawyer – They offer a free incorporation service with their Accelerate subscription service, which runs $49.95 and includes a number of other legal related services.
IncFile – Considered the deep discounter in the incorporation space.
Ongoing Record Keeping Requirements
Before choosing a business structure, you should be aware of the cost and time involved in maintaining the business on a daily, monthly, and annual basis.
Sole Proprietorship – A sole proprietorship has very few ongoing requirements. You may have to renew local permits or pass local inspections. Trade name filings are usually good for 5 years. Although we recommend that you separate business and personal assets, this isn’t a legal requirement for sole proprietorships, so accounting can also be simpler for sole proprietorships.
General and Limited Partnership – Like sole proprietorships, partnerships also carry few if any ongoing formalities, other than renewing local licenses and trade name filings. If your partnership agreement requires certain formalities to keep the partnership active, be sure to do those.
Corporations – Of all the different business types, corporations are the hardest to maintain. Corporations must hold annual board meetings and shareholder meetings. Most decisions in running the corporation must be made by a formal vote and (in most states) memorialized in meeting minutes. Meetings must have a proper quorum. You should keep meeting minutes, as well as other documents such as stock ledgers, at your business location. In addition, virtually all states require corporations to submit an annual report. Meeting these requirements can take a significant amount of time if you’re not familiar with your state’s corporate law.
These ongoing requirements can be adapted for single-person corporations. For example, you must issue a stock certificate to yourself identifying you as the sole shareholder. You must also keep written records of your business decisions. Read this article for more details on running single-member corporations.
LLCs – The ongoing requirements for an LLC are less onerous than corporate formalities. You’re not legally required to hold member meetings or issue membership shares, although it may be a good idea to do so. You must file a statement or report with the state every year, but this is usually pretty inexpensive (around $20-50). If your LLC operating agreement requires other formalities to maintain the business, be sure to do those.
Personal Liability for Business Obligations
If you’re trying to form a business that exposes you to potential liability, such as a construction or food-related business, you should seriously consider choosing a business structure that shields you from personal liability for business activities. Even if your business is in a “safer” industry, protecting yourself from personal liability is important because you can otherwise be held personally responsible for business’ debts.
Sole Proprietorship – A sole proprietorship, while easy to form and maintain, provides no personal liability protection from the business’ debts and legal obligations. This means that creditors of the business can come after your personal assets (e.g. your car and home) if the business loses a lawsuit or racks up debt. Imagine that Susie, a sole proprietor, borrows money for her construction business. She loses a major customer, causing the business to fold. Susie is now personally obligated to pay back the loan. If she doesn’t have the funds to pay it back, the creditor could get a court order to have her house or other personal assets sold to satisfy the debt.
If you’ve purchased an independent liability insurance policy or if your business is well funded and in an industry where liabilities are few and far between (e.g. retail), then a sole proprietorship may be a safe choice.
General Partnership – Like sole proprietorships, general partnerships leave you open to personal liability. Every partner is fully liable for the business’ debts and obligations and for the actions of other partners. For example, if you own a spa, and your partner negligently injures a client during a massage, you could potentially be on the hook for that.
Limited Partnership – A limited partnership offers more liability protection than a general partnership because it creates two classes of partners. “General partners” run the business and assume liability for the partnership. “Limited partners” invest in the business but don’t participate in its day-to-day management; they are not liable for the partnership’s debts and obligations. Having two classes of partners makes it easier to raise money (see more on this below), but the general partners who are running the day to day business still don’t have liability protection. Most of you reading this article are probably general partners. For you, a limited partnership won’t be much better than a general partnership from the standpoint of liability.
Corporations – The biggest advantage of forming a corporation is that you cannot be held personally liable for the corporation’s debts or legal obligations. The corporation is an entity separate from its owners and can be sued or held accountable apart from its owners. However, in cases of misconduct, the court will “pierce the corporate veil” and find officers and directors to be personally liable. In addition, if you personally guarantee a loan, you forfeit the limited liability that normally comes with doing business as an corporation.
LLCs – When it comes to liability, an LLC is just like a corporation. Members of an LLC are shielded from personal liability for the business’ debts and obligations. Exceptions to this rule exist in cases of misconduct. In addition, as with corporations, personally guaranteeing a loan forfeits limited liability.
If you plan to raise money for your business, then you should choose a business structure that facilitates investment.
Sole proprietorships – In general, a sole proprietorship is not ideal for raising money. Since business successes and failures are tied to one owner, sole proprietorships are riskier investment opportunities, and investors tend to shy away from them. If you want to remain the sole owner, you cannot incentivize investors by selling a stake in the business.
Banks also hesitate to loan to sole proprietorships because of the perceived continuity risks of a one-person shop (e.g. what happens if the owner becomes ill?). Moreover, since a sole proprietorship is not an entity apart from the owner, you cannot borrow money under the business’ name. You must rely on personal funds or take out a consumer loan.
General partnerships – General partnerships are also not well suited for raising money. You cannot attract an investor by selling a stake in the partnership because that would make the investor a general partner. He or she would have to assume liability for the partnership, even if they don’t participate it its daily operation. Most investors don’t want to take on that kind of liability.
Limited partnerships – Limited partnerships find it easier to raise money because the owners can sell a stake in the partnership to investors. Investors can serve as “silent” limited partners without assuming liability for the business or partaking in daily business operations. Limited partners generally can’t lose more money than they invest in the business.
Corporations – It is easiest for a corporation to raise money because it can issue stock. Investors can get a piece of the pie without facing liability for the corporation’s mistakes. C Corporations are better situated for raising money than S Corporations because C Corporations allow multiple classes of stock and have no limit on the number of shareholders (S Corporations are limited to to 100 shareholders). C Corporations are required if you’re planning on investing your retirement money in your own business, a process called a rollover for business startups.
Banks are more likely to lend to corporations than to sole proprietorships or partnerships because multiple layers of corporate formalities spread out decision making responsibility and reduce risk.
LLCs – It’s pretty easy to raise money as an LLC because you can sell membership interests to investors. However, investors generally prefer stock to LLC membership because the latter could increase their tax bill (more on that below). Also, investors like corporations because an IPO can be their “big pay off.” In contrast, LLCs are always privately held businesses.
To learn more about funding options for small businesses, check out our guide Start Up Business Loans: The 9 Best Options.
Most people’s reasons for choosing one business structure over another is the tax bill. While this shouldn’t be your only consideration, it is an important one.
Sole proprietorships – Sole proprietorships are pretty attractive from a tax standpoint. The business income and losses “pass through” to and are reported on your personal income tax return. There is no separate business tax return. This is a plus because business losses can offset personal income from other sources, reducing your overall tax burden. You pay a similar tax rate to what you would if the money came from an employer.
General partnerships – General partnerships are similar to sole proprietorships for tax purposes. They are “pass-through” entities, so the partnership’s income and expenses are reported on each partner’s personal income tax return. Each partner pays taxes on his or her share of the profits as defined in the partnership agreement. You pay a similar tax rate to what you would if the money came from an employer.
General partners must also pay the federal self-employment tax.
Limited partnerships – Limited partnerships are taxed similarly to general partnerships, except limited partners do not have to pay a self-employment tax because they are not involved in running the business. In addition, some states have an annual tax on limited partnerships, but this generally isn’t very high (California’s annual tax, one of the highest, is $800).
Corporations – Corporations are not as tax friendly as sole proprietorships and partnerships. In fact, a frequent complaint about C corporations is that they subject you to “double taxation.”
Income from a C Corporation is first taxed at the current corporate tax rate of up to 35% (see current corporate tax rates here). Income that is paid out to shareholders in the form of salary is then taxed again at the recipient’s personal income tax rate. Income that is paid out as dividends to shareholders is also taxed at the current dividend rate of up to 20%.
If the corporation meets certain restrictions, it can elect to be treated as an S Corporation from a tax standpoint in order to avoid double taxation. In an S Corporation, incomes passes through from the business to your personal tax return. There is no need to file a corporate tax return.
LLCs – After setting up an LLC, if no election is made with the IRS, then income from the LLC will pass through to the owners in the same manner as it does with a sole proprietorship or general partnership. However, LLC’s can also elect to be treated as a C Corporation or an S Corporation from a tax standpoint. Many LLCs elect S Corp tax status. We reached out to some tax specialists about the advantages and disadvantages of electing S Corp tax status for your LLC.
Professionals agree that most LLC owners will have a lower tax bill if they elect S Corp status. Normally, LLC owners must pay a 15.3 % self employment tax on all of the business income (this is how self-employed people contribute to medicare and social security). If you elect S Corp status, you can give yourself a reasonable salary from the business income and treat the remaining income as unearned distributions. Distributions are not subject to the self-employment tax, so this will lower your tax bill.
Kolonji Murrary, the owner of Tax Assurances in New York City, told us that LLC owners should carefully weigh the pros and cons of S Corp status because avoiding the self-employment tax can have unintended consequences. You may end up not saving enough for yourself for retirement. Also, the IRS more carefully scrutinizes S Corporations because your income is divided between wages and distributions.
Your election of LLC or S Corp status for tax purposes will also be affected by the tax rules in your state. For instance,California charges an LLC tax based on the business’ gross receipts. Jared R. Callister, a tax attorney with Fishman Larsen Chaltraw & Zeitler, told us that this is why ‘many grocery stores or other businesses with high sales and low margins prefer to operate as S corporations.”
If you have an LLC and are currently taxed as a C Corporation but desire to return to being taxed as a sole proprietorship (single member LLC) or partnership (multi-member LLC), then you would use Form 8832.
When choosing a business structure, you should think not only about your business’ current needs, but also about what your business will need in the future. It can be expensive and time consuming to switch business structures, so try to choose a structure now that can adapt with your business.
Sole proprietorships – Sole proprietorships are quite flexible. You have complete control over management decisions without having to answer to partners, directors, or shareholders. You can work as much or as little as you want. In addition, you can easily sell a sole proprietorship if you decide that you no longer want to run the business.
Partnerships – Partnerships can be flexible, but just how much depends on your partnership agreement. In the absence of an agreement, one partner can freely make decisions on behalf of other partners without their consent. However, partnerships can also dissolve easily. If the partnership agreement doesn’t define the rules for dissolution, a partnership can be dissolved when one partner gives notice that he or she wants to end the business.
Corporations – Because of all the formalities that corporations must adhere to, they are not very flexible. As mentioned above, most management decisions must be approved by the board in a formal meeting. Even closing down the business requires a formal vote, and dissolution forms and/or tax clearances must be filed with the state. A one-person corporation is more flexible since one person serves as officer, shareholder, and director.
LLCs – Many small businesses choose to operate as LLCs precisely because of the flexibility that they offer. The operating agreement allows you to specify how much say different members have in the management of the business. An LLC can be managed by its members or by elected managers. You can also choose for your LLC to be taxed as a partnership or a corporation. In many cases, choosing to be taxed as an S Corp gives you the benefits of operational flexibility and a lower tax burden. You can either choose to observe corporate formalities or ignore them. On the downside, dissolution procedures for LLCs are not that flexible, and there’s a risk that small business owners might unintentionally dissolve the business.
Ultimately, the business structure that you choose will depend on your business needs now and in the future. We recommend that you consider setup procedure and cost, ongoing formalities, personal liability, ease of raising money, tax advantages, and flexibility when selecting a business structure. Most of the time, it will be a combination of these factors and no single factor that leads you to your choice. For business specific advice, consult an attorney.
That’s our article for today. If you have any questions or comments please leave them in the comments section below. Also be sure to read the next article where we will continue our series on how to start a successful business with a look at patents and trademarks.
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