Comparing Business Legal Structures
- Lesson Materials Business Legal Structure Cheat Sheet
- Completion time About 25 minutes
For the first-time business owner, choosing the best organizational structure for your company can seem like a daunting task. What exactly is an LLC? What are the differences between C-corporations and S-corporations? Is a sole proprietorship a good idea?
Confusion is common, and the devils are in the details, so make sure you know the advantages and drawbacks of each business formation so you can make the best choice for your company. Below, we’ll compare the pros and cons of each business legal structure.
Sole Proprietorships & Partnerships
A sole proprietorship is an ideal structure for a person who wants to own a business on their own. It’s as easy as starting a business, requiring no paperwork whatsoever.
A partnership is effectively like a sole proprietorship, except that it’s owned by two or more people, and typically is governed by a partnership agreement.
- Simple Setup: Sole proprietorships/partnerships are among the easiest organizational structures to set up.
- Few Fees and Oversight: Sole proprietorships/partnerships don’t require much in the way of fees or regulations.
- Minimal Liability Protection: Sole proprietorships/partnerships do not have liability protection. Therefore, if the business fails, the personal assets of you (and your partners) can be used to satisfy the business’ debt.
A partnership or sole proprietorship is most beneficial for a single owner or close set of business partners who want to set up shop quickly and easily, and have the personal assets to protect their business.
Limited Liability Company (LLC)
For a small-business owner, an LLC—or limited liability company—is the most popular choice. In fact, 80% of small businesses choose this organizational structure, citing its flexibility and the protections it offers by and limiting the legal liabilities of its members.
An LLC is a private limited company and, unlike a corporation, has a much more freedom in two important areas: organizational structure and taxation.
The organizational structure of an LLC is notable for its flexibility. There are no formal restrictions on LLC structure, which is frequently beneficial for new companies, particularly as they expand in size and profitability. Conversely, corporations have quite rigid organizational restrictions, such requiring of a Board of Directors, and so are not conducive to the mercurial nature of startups and many new businesses.
For taxation purposes, the IRS classifies an LLC as pass-through entities, which means they are only taxed once, at the individual level. The LLC itself pays no taxes. Corporations, on the other hand, are taxed at both the company level and the individual level, which is often a strong disincentive for new businesses to form with that structure.
Pros of LLCs
There are a number of advantages to forming your company as an LLC.
- Protection of Personal Assets: Your business becomes its own entity, protecting you and any partners from personal liability. Any debts incurred by an LLC belong to the LLC itself, rather than to the owners of the company.
- Flexible Structure: An LLC can be run like a corporation (with a board of directors who make decisions), but it also can be run as a partnership, where each member has a say in the day-to-day decisions.
- Flexible Profit Distribution: With an LLC, you’re at liberty to make your own choices regarding the distribution of profits; this is not tied to the amount of “stake” a member has in your company.
- Easier Taxes: LLCs offer pass-through taxation, which effectively means you simply claim your business profits (or losses) on your individual income tax return, which means an LLC requires less record-keeping than an S-corp.
- No Ownership Restrictions: The LLC structure carries no ownership restrictions. Foreign entities, individuals, and even other LLCs can all be named as owners. However, you don’t have to have other owners at all: you can operate an LLC as a single member.
Cons of LLCs
- No Owner Wages: You cannot actually pay yourself “wages.” Your income comes as a portion of the LLC’s profits.
- Investor Limitations: Taxation of partnerships like LCCs is overly burdensome for investors, involving specialized tax forms, and some investors can’t even invest in LLCs in the first place because of tax-exempt statuses. So if you plan to seek outside investment, an LLC structure may be less attractive than a corporation.
Do note that you may have to file a business tax return, even if no taxes are paid at the business level, if the LLC is owned by two or more people.
The LLC organizational style is best suited to high-risk small businesses, as the structure limits personal liability. It may also be beneficial for businesses seeking flexibility.
The S-corp entity type has a lot in common with an LLC. Both are considered limited-liability, protecting your personal assets from being seized for business debt. Both offer pass-through taxation, effectively sheltering owners from higher business tax rates.
There are some differences, however. Namely, an S-corp is bound by more rules and requirements than an LLC.
Pros of S-Corp
- Long-term Stability: Some states actually require LLCs to list an ending date (called a dissolution date) when paperwork is filed to form the LLC. So, for instance, you might say that your LLC will dissolve in 20 years. However, an S-corp’s designation will remain in perpetuity, which is a better fit for a business that plans to be in it for the long haul.
- No Business Taxes: No taxes are paid at the business level (however annual tax filing is still required).
- Save on Taxes: An S-corp allows owners to effectively pay themselves (and reduce taxes) by determining a reasonable salary and taking the remaining profits as dividend pay. This cuts down on your self-employment tax obligations, which can save you thousands of dollars a year. You can calculate how much you can save on your own self-employment and payroll taxes by choosing an S-corp.
An S-Corp is preferable to an LLC in specific situations, particularly when it comes to taxation. S-corp owners’ salaries are often self-determined and taxed as income, however dividends are paid—and thus taxed—separately. This can save 10% to 15% in taxes over the course of the year, though bookkeeping and related costs will be higher than they are for an LLC.
Cons of S-Corps
- Limited Shareholders: The number of shareholders is capped at 75, whereas an LLC can have unlimited shareholders.
- Restricted Ownership Rules: For c-corps, ownership restrictions are also tighter: all owners in an S-corp must be U.S. citizens. Additionally, S-corps must have a board of directors who manage at the corporate level, then appoint officers to manage the daily activities.
- Profit Distribution Rules: An S-corp must tie its profit distribution to a stakeholder’s share: a 30% stake in the company mandates an entitlement to 30% of the profits.
- Financial Tracking Requirements: These come along with the S-corp’s hefty tax advantages, including quarterly IRS payments and some pretty stringent rules and regulations. This includes filing a business tax return, despite there being no taxes at the business level.
S-corporations are useful for business owners who wish to pay themselves salaries, take advantage of the tax savings that come with a dividend structure, and/or want to make their companies permanent entities. The S-corp structure also simplifies the steps required to transfer ownership or shut down the business.
The C-corp stands out among other business structures because they are taxable entities. This allows the tax burden to be split between the corporation itself and the owners, with the benefit that each is placed in a lower tax bracket than under other business structures. C-corps tend to be more complex than LLCs and S-corps and so incur higher costs for accounting and legal matters as well.
Outside of taxes, in other structural particulars C-corps are generally similar to S-corps, but they do have a some key differences:
- Flexible Ownership: C-corps offer more flexibility than an S-corp in terms of ownership, functioning much more like an LLC in this area.
- Single Stock Class: C-corps can have multiple stock classes, whereas an S-corp is only allowed one.
- Double Taxation: The major C-corps drawback is that they are taxed twice; once on the corporation’s net income, and again when the profits of the corporation are distributed to its shareholders.
C-corps are an ideal structure for larger, well-established companies that have little risk of failure, and companies that want to raise capital by utilizing multiple stock class options.
The nonprofit structure is specifically for organizations that aim to contribute to the greater good, and are conferred special status in various ways. However, there are numerous regulations for this entity type and it should only be chosen in very specific and well-thought-out circumstances.
Pros of Nonprofits
- Tax Exemptions: The primary draw of this structure, because a nonprofit provides a public service, it is exempt from federal, state, and local taxes.
- Organizational Profits Allowed: Contrary to popular belief (and the name itself), nonprofits are allowed to make a profit in order to pay for things like overhead and employee salaries.
Cons of Nonprofits
- Strict Operational Requirements: Nonprofits’ tax exemptions only come if the company’s main purpose directly benefits the public.
- Personal Profit is Limited: The income cannot act as profit for any officer or director of the company.
If your business’ main priority is to benefit the public, a nonprofit is the logical choice, as the business will be exempt from all taxation.
Which Structure Works for You?
The overwhelming majority of new businesses, and almost all startups, take the form of either an LLC or an S-Corp, but the choice may still not be clear. So how do you choose between an S-corp and an LLC?
Ask yourself if you are:
(A) Comfortable with a capped amount of shareholders, confident in your ability to make quarterly IRS payments, and able to keep up with the stringent rules and regulations that go hand in hand with significant tax advantages?
(B) Willing to take on the additional risk that comes with having your personal assets tied to your business? Do you enjoy the control that comes with making your own decisions and not being held accountable to a large number of other owners?
(C) Able to pay the high set up fees that are required to file your Articles of Incorporation? Are you comfortable with a significant amount of government oversight in exchange for benefits such as perpetual existence and no shareholder cap?
(D) Looking for more flexibility regarding your company’s owners? Do you prefer to make your own decisions about how your profits should be distributed? Would you rather focus on your business instead of record-keeping?
If you said A, an S-corp is probably right for your company.
If you said B, a sole proprietorship or partnership may be in your best interests.
If you chose C, a C-corp will best align with your preferences.
If you chose D, then an LLC is the best option
Choosing which business structure to use is one of the most important decisions you’ll make when it comes to your new company. When you’re armed with all the necessary information, the solution becomes much clearer.
- Lesson Materials Business Legal Structure Cheat Sheet