Legal Structure of Your Business
How To Choose A Legal Structure For Your Business
Deciding how to legally structure your business can become very tricky. They each have their pros and cons and it’s best to talk to your lawyer or CPA to decide which is right for you.
Sole Proprietorship or Partnership
Most businesses will automatically be a sole proprietorship or partnership unless asked to be otherwise. The business owner(s) will report all business income or losses on their personal tax returns as the business itself is not taxed separately. Beware however, by being a sole proprietor, you have unlimited liability to the company and its debts. Therefore, if you were to be sued or fall behind on debt payments, your personal assets (house, cars, etc.) could be at risk.
In recent years, the LLC has become the most popular way for small businesses to get started. An LLC, or Limited Liability Company isn’t taxed any differently than a sole proprietorship, but offers the limited protection of a corporation. The LLC is a recent addition to business legal structures, so be sure to check with your state to find out if they recognize LLCs. As an LLC, the owners can use losses to offset income but only up to the amount they’ve invested. With an LLC, your personal assets have more protection (but not 100%) than a sole proprietorship. Be aware that an LLC can be subject to additional state or franchise taxes.
C Corps are taxable entities, meaning that the corporation is taxed on its income rather than the individual owners being taxed. This can be advantageous to the owner(s) because a C Corp can use a strategy known as “income splitting”. Income splitting is dividing the companies income between the company and the owners, meaning part is taxable to the corporation and part is taxable to the owner(s). This could put each into a lower tax bracket for tax savings. One disadvantage to C Corps is they can be subject to double taxation on any dividends paid out to share holders. The corporation will be taxed on its income and then the shareholders will be taxed on their dividends.
S Corps can provide some tax savings due to the fact that they don’t have to pay self-employment taxes on their profits. However, before they are allowed to pay out any dividends to share holders, they are required to pay owner-employees a “reasonable salary.” This salary is subject to Social Security and Medicare taxes (which would be the sum of self-employment tax). S Corps only see tax savings when the income of the company reaches a sizable amount. Both C Corps and S Corps are very complicated and will typically cost more in attorney and accountant fees come tax time.
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