The Pros and Cons of Various Business Structures
As a business owner, it’s important to choose the right type of business entity structure for your organization. Your business entity structure can have a major impact on your tax liabilities, your ability to raise capital, your personal liability and your business continuity.
Following are five types of business structures and the pros and cons of each.
#1 – Sole proprietorship
Most small businesses begin as sole proprietorships. This structure is easy to establish and allows the owner to retain complete control of the business. Sole proprietorships are typically started by freelancers, independent contractors, consultants and other home-based business owners. They can be a smart choice for low-risk businesses and those who wish to test the waters while starting a new business before entering into a more complex structure.
Advantages of sole proprietorships include:
- Simple and inexpensive to establish – There are no forms or government fees required to start a sole proprietorship.
- Greater control – As the sole business owner, you retain complete control over all business decisions.
- 100% of profits – You’re able to retain all profits, and you’re only taxed once on the business’s income.
- Increased privacy – Because sole proprietorships aren’t required to file annual reports with federal or state governments, they’re not subject to public disclosure requirements.
- Tax return reporting – The income or loss of the business is reported on a schedule that gets attached to the owner’s personal income tax return, so another tax return filing isn’t required.
Disadvantages of sole proprietorships include:
- Tax liabilities – You’re required to pay personal income tax on all business profits as well as self-employment taxes to cover Social Security and Medicare obligations.
- Unlimited personal liability – A sole proprietorship doesn’t protect you from liability should something go wrong with your business. This means you may be putting your personal assets — including your home — at risk.
- Challenges with fundraising – As a sole proprietor, you won’t be able to sell equity to raise money, and most banks won’t make loans to sole proprietorships without the personal guarantee of the owner.
#2 – Partnership
The next business structure option is a partnership, where two or more partners join together in a business venture. There are two main types of partnerships:
- Limited partnerships (LPs) – An LP is the easiest way for multiple partners to structure a business. One partner typically serves as a general partner and takes on unlimited liability, while the other partners maintain limited liability. In exchange for the added liability, the general partner typically has more control over business decisions than limited liability partners.
- Limited liability partnerships (LLPs) – LLPs provide limited liability protection to all business partners. LLPs are particularly well-suited to professional groups, such as lawyers or accountants. Some states only allow LLPs to be available to professionals.
Advantages of partnerships include:
- Personal liability protection – In contrast to sole proprietorships, partnerships operate as separate legal entities, which provides a level of personal liability protection to the limited liability business owners.
- Easy to establish – Executing a partnership agreement is typically the most time-consuming part of establishing a partnership. The legal requirements of establishing a partnership are generally straightforward and inexpensive.
- Shared mission – Starting a business with partners allows you to share the responsibilities of running a business with others.
Disadvantages of partnerships include:
- Liability for others – If something goes wrong in the business, you may be legally liable for the actions of your business partners, especially if you’re acting as the general partner of an LP. An LLP, however, protects each partner from debts against the partnership arising from negligence or malpractice claims made against other partners.
- Shared profits – Just as you share responsibilities with your business partners, so must you share any profits generated by the business.
- Disagreements – Within a partnership, business decisions must be made by all partners based on the terms of the partnership agreement. This structure can result in conflicts and disagreements if not all partners are on the same page.
#3 – Limited liability company (LLC)
LLCs combine the operational flexibility of a sole proprietorship with the liability protection of a corporation. The process of forming an LLC is more complex than the process of forming a sole proprietorship or partnership, which is why it’s wise to enlist the help of a qualified attorney. LLCs make sense for business owners with significant assets they wish to protect. LLCs can have multiple members or be formed with one owner as a single member. Multi-member LLCs most often file a partnership income tax return.
Advantages of LLCs include:
- Legal protection – Because LLCs are structured as separate legal entities, business owners are protected from personal liability related to lawsuits, bankruptcy and business debts.
- Profit distribution flexibility – LLCs provide flexibility for business owners to decide how profits are distributed to various members. The allocation needs to have a substantial economic effect.
- Tax efficiencies – Under an LLC structure, income and expenses pass directly to the owners’ personal tax returns, and the owners pay taxes on the profits they receive. This is more advantageous than the double taxation of C corporations.
- State pass-through entity taxes – Many states allow LLCs to pay state taxes at the entity level and then pass through a credit to their owners versus having the owners pay the state taxes at the individual level. This allows the LLC to deduct the state taxes versus the owner not being able to deduct them due to the individual state and local tax (SALT) cap deduction or the individual taking the standard deduction.
Disadvantages of LLCs include:
- Higher costs – LLCs are more expensive to establish than sole proprietorships. Ongoing, they’re subject to multiple administration costs, including reporting fees, state-imposed fees, registered agent fees and costs associated with implementing an operating agreement.
- Personal tax exposure – Because income passes directly to the owners, depending on the trade or business of the LLC and the level of involvement of its owners, the income can be subject to self-employment tax. The downside of being taxed as a self-employed individual is that you must pay self-employment taxes to cover Social Security and Medicare obligations.
#4 – C corporation
C corporations are legal entities that exist independently of the business owner(s). C corporations can be taxed, make a profit and be held legally liable as an entity.
A C corporation structure often makes sense for medium- to high-risk businesses, because it provides personal liability protection for business owners. This structure can also be a good option for businesses that plan to raise capital or go public in the future.
Advantages of C corporations include:
- Limited liability – Because C corporations operate as separate legal entities, business owners’ personal assets are protected from legal judgements, business debts and certain other liabilities.
- Capital raising potential – C corporations have the option to raise capital by selling shares of company stock.
- Business continuity – Because they operate independently of business owners, C corporations can continue operating uninterrupted when a shareholder leaves the company or sells shares.
Disadvantages of C corporations include:
- Tax disadvantages – C corporation profits are taxed to the corporation when earned then taxed again to the shareholders when distributed to them as a dividend. This means shareholders are taxed twice on the same income. Another tax disadvantage of C corporations is that shareholders can’t deduct corporate losses on their personal returns.
- More complex and expensive – When compared to a sole proprietorship, partnership or LLC, C corporations are more expensive and complex to establish and maintain.
- Reporting requirements – C corporations require regular reporting to the Secretary of State. They also require the filing of their own income tax return.
#5 – S corporation
An S corporation is a business structure designed to help owners avoid the double taxation associated with C corporations. S corporations are taxed as pass-through entities, which means income, losses, deductions and credits pass through to the shareholders who then report these items on their personal income tax filings. It’s important to note that IRS approval is required for S election status.
Advantages of S corporations include:
- Pass-through taxation – Business owners are not double taxed on profits and are able to claim business income, losses, deductions and credits on their personal tax returns without being subject to corporate taxes.
- Limited liability – Similar to C corporations, S corporation owners can’t be held personally liable for legal judgements, business debts or certain other liabilities.
- Business continuity – S corporations can continue operating uninterrupted when a shareholder leaves the company or sells shares. However, there are allocation rules that S corporations need to be aware of if changes in ownership occur.
- Flexible compensation – Business owners can receive both a salary and distributions.
- State pass-through entity taxes – Many states allow LLCs to pay state taxes at the entity level and then pass through a credit to their owners versus having the owners pay the state taxes at the individual level. Doing so allows the LLC to deduct the state taxes versus the owner not being able to deduct them due to the individual SALT cap deduction or the individual taking the standard deduction.
Disadvantages of S corporations include:
- IRS scrutiny – The IRS must approve a business’s desire to register as an S corporation due to the fact that certain entities can’t be S corporation shareholders. S corporations are also subject to additional IRS scrutiny regarding employee compensation, because it can be easy to disguise salaries as corporation distributions to avoid paying payroll taxes. Because of this, it’s important to pay reasonable salaries to your shareholder-employees before making any distributions.
- Complex filing requirements – S corporations must file Articles of Incorporation or a Certificate of Incorporation with state authorities. They must also complete IRS Form 2553 to elect S corporation status.
- Higher fees – Many states require that S corporations pay franchise taxes, annual reporting fees and additional miscellaneous fees.
Could you use help determining which type of structure makes sense for your business? Creative Planning Business Services is here for you. Our experienced professionals partner with clients to help them optimize all aspects of their organizations and drive success for their businesses. To learn more, schedule a call with a member of our team.
