When you’re starting a new business, you’ll have to choose the type of business structure that’s right for it. Knowing the differences between the types of structures and what each one has to offer can help you choose the right business entity — a decision that’ll affect your taxes, income and legal liability.[1] When making such a decision, you should always consult your attorney or financial professional.
Common types of businesses
There are five main types of business entities to consider. Let’s take a look at what each one offers and which advantages and disadvantages you need to consider.[2]
Sole proprietorship
A sole proprietorship is a simple and common type of business structure. It’s the easiest type of company to form and is often the right choice for a one-person operation.[3] If you’re going to work alone, this could be the right choice for you.
This entity is also the simplest in terms of taxes because you’ll file them on your personal income tax return.[4] Rather than filing a separate set of taxes for your company, you’ll record your profits and losses and file this with your personal taxes.[5] Then, after deducting your business losses from your income, you calculate the amount of self-employment tax that you have to pay.[6]
The main downside of a sole proprietorship is that you’re taking responsibility for any of your company’s liabilities. This type of business is not a legal entity that’s separate from you, and you’re personally liable for its debts.[7] That means if you are sued or accumulate business debt, your personal assets could be seized to resolve the financial obligation.
Partnership
When you have one or more partners working with you, a partnership could be the solution. There are two types of partnerships: general and limited. In general partnerships, the partners all manage the company and agree to assume responsibility for the partnership’s business debts.[8]
A limited partnership has a general partner running and managing the business, while the other partners have limited liability that doesn’t exceed the amount of their investment in the business.[9]
One of the biggest advantages of a partnership is that it doesn’t pay taxes on its income, but instead the profits and losses are passed through to individual partners. They each file a Schedule K-1 form showing their individual share of income, deductions and tax credits. The partnership itself does not pay income tax.[10]
If you’re considering choosing a partnership structure, make sure you have a good business agreement in writing to clarify the roles and responsibilities of all partners. You must register it through your local Secretary of State and will need to follow state guidelines to obtain the required local, state and federal permits or licenses.[11]
C Corporation
A corporate business entity is generally a more complex and expensive type of business structure. It’s independent from its owners and is its own legal entity, which means it has many more regulations and tax requirements than other structures.[12]
For a small business, the main benefit is that its owner is protected from liability. Because the C corporation’s debt is separate from its owner, you won’t risk your own personal assets.[13] The corporation also can keep its profits without its owners having to pay separate taxes on them. C corporations pay corporate taxes.[14]
However, there are several things to beware of when it comes to corporations. Because they have to follow complex regulations, they also require more accounting and tax services, which may make them more expensive to run. The business will have to pay corporate federal and state tax as well as earnings that you’ve distributed to shareholders as dividends.
Additionally, the corporation must follow some other requirements, including the need to issue stock, file annual reports and hold annual meetings.[15] Consulting an attorney or financial professional is recommended.
S Corporation
One attractive option for many small business owners is the S corporation, which gives owners the liability protection of a corporation without the same level of taxes. The income and losses are passed through and included on shareholders’ individual tax returns, so you’ll pay fewer taxes.[16]
However, S corporations are still corporations, which means they have many of the same requirements, such as holding meetings and keeping minutes. As a result, you might pay more in tax and accounting services than you would with sole proprietorships or partnerships. You may also encounter legal and accounting costs when you’re setting up the entity, similarly to if you were creating a standard corporation. Consulting an attorney or financial professional is recommended.
Limited Liability Company
A limited liability company, or LLC, has some great benefits. From a tax perspective, the setup is simple, and the profits and losses are taxed on the owner’s individual returns.[17] That means potentially lower accounting and tax-preparation costs. The “limited liability” component means that the only financial risk is the money you put into the business; you cannot be held personally responsible for the entity’s business debts.[18]
One thing to be aware of if you’re considering an LLC is that there’s a large amount of paperwork to be filed, and some of that paperwork is ongoing. Also, you’ll have to pay self-employment taxes, which are calculated on your profits. Consulting a tax professional is recommended.
Which business structure is right for you?
There’s no one-size-fits-all solution to finding the best business entity for your needs. Looking at the pros and cons of each one and talking with a qualified tax and financial expert or attorney about your options, can help you find the one that fits you — and your business — best. Make sure to look into business insurance options to determine the right amount of liability insurance you need.
As you get your company off the ground, it’s important to hire the right kind of talent. Use these tips to attract high-quality applicants.
Disclaimer: The information presented in this article was obtained from sources believed to be reliable to help users address their own risk management and insurance needs. It does not and is not intended to provide legal or tax advice. Individuals should consult their own attorney or tax professional for guidance. Nationwide, its affiliates and employees do not guarantee improved results based upon the information contained herein and assume no liability in connection with the information or the provided suggestions. Nationwide, Nationwide is on your side, and the Nationwide N and Eagle are service marks of Nationwide Mutual Insurance Company. © 2020 Nationwide
[1] “Compare Tax Considerations by Business Type,” Wolters Kluwer, https://www.bizfilings.com/toolkit/research-topics/managing-your-taxes/compare-tax-considerations-by-business-type, (Accessed November 7, 2019).
[2] “Choose Your Business Structure,” Entrepreneur.com, https://www.entrepreneur.com/article/38822, (downloaded Oct. 25, 2019).
[3] “Sole Proprietorship,” Entrepreneur, https://www.entrepreneur.com/encyclopedia/sole-proprietorship, (accessed November 7, 2019).
[4] “Sole Proprietorship,” Entrepreneur, https://www.entrepreneur.com/encyclopedia/sole-proprietorship, (accessed November 7, 2019).
[5] “Sole Proprietorship,” Entrepreneur, https://www.entrepreneur.com/encyclopedia/sole-proprietorship, (accessed November 7, 2019).
[6] “Sole Proprietorship,” Entrepreneur, https://www.entrepreneur.com/encyclopedia/sole-proprietorship, (accessed November 7, 2019).
[7] “Sole Proprietorship,” Entrepreneur, https://www.entrepreneur.com/encyclopedia/sole-proprietorship, (accessed November 7, 2019).
[8] “What Is a General Partnership?,” Investopedia, https://www.investopedia.com/terms/g/generalpartnership.asp, (downloaded Oct. 25, 2019).
[9] “What Is a Limited Partnership (LP)?,” Investopedia, https://www.investopedia.com/terms/l/limitedpartnership.asp, (downloaded Oct. 25, 2019).
[10] “Partnerships,” Internal Revenue Service, https://www.irs.gov/businesses/partnerships, (Accessed November 7, 2019).
[11] “Register your business,” U.S. Small Business Administration, https://www.sba.gov/business-guide/launch-your-business/register-your-business, (Accessed November 7, 2019).
[12] “Types of Business Entities: Pros, Cons, and How to Choose,” Fundera, https://www.fundera.com/blog/business-entity, (Accessed November 7, 2019).
[13] “C Corporation,” Investopedia, https://www.investopedia.com/terms/c/c-corporation.asp, (Accessed November 7, 2019).
[14] “C Corporation,” Investopedia, https://www.investopedia.com/terms/c/c-corporation.asp, (Accessed November 7, 2019).
[15] “C Corporation,” Investopedia, https://www.investopedia.com/terms/c/c-corporation.asp, (Accessed November 7, 2019).
[16] “Tax Benefits of S-Corporations,” Brinker Simpson, https://www.brinkersimpson.com/blog/tax-benefits-of-s-corporations, (Accessed November 7, 2019).
[17] “How LLC Members Are Taxed,” NOLO, https://www.nolo.com/legal-encyclopedia/how-llcs-are-taxed-29675.html, (Accessed November 7, 2019).
[18] “What Are Owners Liable For in an LLC?” Legal Zoom,https://info.legalzoom.com/article/parent-company-liable-when-llc-sued, (Accessed November 7, 2019).
