Whether you’re new to entrepreneurship or you’ve been in business for years with a full staff and profitable company behind you, the need to evaluate (or re-evaluate) your business structure regularly will never disappear. The two main reasons: taxes and liabilities (sometimes the two go hand-in-hand).
Many businesses start as sole proprietorships because the structure is relatively fast, cheap, and easy to set up. With a sole proprietorship, there’s no separation between your business and your personal assets and expenses. The money you make can go directly into your personal bank account, no paying business licensing fees or following complicated payroll tax systems to pay yourself.
However, this is rarely a homerun benefit for profitable business owners. Sole proprietors are personally responsible for any legal or financial liabilities that befall their business. If you deal with supplies, materials, labor costs, employees, and other liabilities, that can be a significant risk. Taxes can also balloon for successful sole proprietors since all profits are taxed as part of your personal income taxes, even if you keep the money in the business.
For many new business owners, the first myth to crush is that their business isn’t “successful” enough for a more formal or separate business structure.
An LLC can be a worthwhile step for an individual owner when it comes to personal liability (an LLC will offer some personal asset protection if the business goes south). However, another misconception should be squashed: An LLC alone won’t affect your taxes. Unless you elect otherwise, you’ll still be responsible for employment taxes on your entire net income, just as a sole proprietor is.
Partnerships, including limited partnerships (LPs) and limited liability partnerships (LLCs), are similar. Depending on how they’re set up, they carry varying degrees of liability for each owner. But before you enter into a partnership, it’s important to consider the potential complications, which we discuss here.
Once the organization begins making more profits and taking on more expenses, many business owners consider whether becoming an employee of the business under a corporation designation is best for tax purposes (and other reasons). An S election (or S corporation) can offer a valuable middle ground for profitable small businesses because it allows shareholders to, essentially, split the difference on taxes between taking distributions of earnings and profits and being paid a salary as an employee. We talk more about S corps here.
But another point of confusion: S corps pass through to the owners their pro-rata share of corporate income, losses, deductions, and credits for federal tax purposes only. Note the “federal” wording. Texas and other states don’t recognize S corp status. In the eyes of the state, you remain either an LLC, partnership, or corporation (C corp) – whatever structure you filed at the state level.
A corporate (C corp) structure comes with the most protections but also the most requirements (including extensive record-keeping, operational, and reporting requirements), not to mention the risk of being “double taxed” on corporate income. So why choose a corporate structure? One answer: Growth. As the U.S. Small Business Administration lays out, corporations:
- Have a completely independent life separate from its shareholders. If a shareholder leaves the company or sells shares, the C corp can continue doing business relatively undisturbed.
- Have an advantage when it comes to raising capital because they can raise funds through the sale of stock, which can also be a benefit in attracting employees.
- Can be a good choice for medium- or higher-risk businesses, those that need to raise money, and businesses that plan to “go public” or eventually be sold.
The bigger your business is—and the bigger you intend on your business becoming—the more a corporate structure makes sense. But it’s certainly not a hard-and-fast rule. For instance, the introduction of the Qualified Business Income (QBI) deduction allowing pass-through business owners (sole proprietors, partners, and S corp owners) the opportunity to deduct up to 20% of QBI has kept some from choosing a corporate structure sooner. Choosing a business structure is also not a “set it and forget it” practice. As your business, needs, goals, and tax laws change, so will your best fit.
One final myth needs addressing: Liability protection can only go so far. A clear example is with payroll taxes. Assuming you have your payroll set up so that employment taxes are automatically deducted, that money must be paid to the government promptly. Until then, it’s considered “trust funds.” The government is “trusting” you to hand it over. When you don’t, you (or whoever in your business is responsible for payroll) are personally liable for the trust fund recovery—no matter how your business is set up. The IRS explains the process here.
In other words, the liability protection that any structure provides is meant to help reputable business owners conduct business with less risk, but it doesn’t protect business owners who break the rules. Feel free to contact us with questions.