If you are thinking about starting a business, or if you’re a serial entrepreneur adding a new line of business, one of the first things you’ll have to do is to determine your business legal structure.
The four most common types and basic forms of business legal structures in the United States include:
- Sole Proprietorship
- Partnership
- Limited Liability Company or an LLC
- Corporation
This post is intended to help you understand which option may be the best fit to meet your business and personal goals and to explain the key differences among the various business structures.
Understand which legal structure may be the best fit to meet your business and personal goals and learn the key differences among the various business structures.
Legal Structure of a Business Plan
A business’s legal structure is a key component in any business plan. Before you can build or start your new business, you’ll need to determine what legal structure will best suit your fledgling enterprise.
In certain cases your choice of a business legal structure will determine which income tax forms you will file annually. It will also determine the type of income taxes you’ll pay on the business’ net income and, more importantly, will have a big impact on the personal liabilities you and your family may face as a consequence of business ownership.
And if you intend to sell your business, its legal structure also will have an impact on many aspects of the sale process and the taxes you eventually will be required to pay.
Sole Proprietorship Definition
A sole proprietorship is a business that is owned by one individual and who has not formed any type of business entity such as a partnership, LLC or corporation. As a sole proprietor, an individual assumes a business identity by selling products or delivering services to others under his or her personal legal name.
Small businesses with a single owner are considered to be a sole proprietorship by default unless they officially form a separate, legal business entity. Owners of a sole proprietorship files their business taxes in conjunction with their personal taxes on a Federal Schedule C.
If an individual wants to use a name for their business activities which differs from their legal individual name, they must file for a fictitious name for the sole proprietorship. A fictitious name is also known as a DBA which is an acronym for ‘Doing Business As’. Those whose chose this type of trade name for their sole proprietorship do not gain any additional protections from legal liability. The fictitious name certificate merely grants the sole proprietor the right to use the alternative DBA trade name on his or her business signs, invoices, investment accounts, leases, business contracts, business checking accounts, etc.
Choosing to be a sole proprietor means the individual owner accepts unlimited liability for the business along with all of its debts, including all known and unknown liabilities. This type of unlimited liability exposure means that in the event the business faces a lawsuit, or does not have the ability to pay any of its debts, the owner’s personal property, assets, and other income will be at risk in addition to the business’s assets.
The unlimited liability nature of a sole proprietor is due to the fact there is no legal separation between the income, assets, and liabilities of an individual and business. Whatever is owned by the individual, including any assets and income built up or earned in the sole proprietor’s business is accessible to any creditor of the individual. The reverse is also true.
Sole Proprietor Tax Treatment
Many people mistakenly believe that if they do not have a business entity formed and they sell products or their services to others, they do not have to report their income and expenses to the IRS. This is not the case. By default, people in this situation are considered to be operating a sole proprietorship.
The advantage to a sole proprietorship is that the owner doesn’t need to file taxes separately or comply with any special government filings or ongoing reporting. However the disadvantage of a sole proprietorship is that if something goes wrong on the business side (debts, liabilities or legal problems), the individual owner may lose both business and personal assets and income. And if the individual or his or her spouse are sued outside of the business, any assets and income associated with a business operated as a sole proprietorship are at risk of loss.
Partnership Definition
Partnerships are essentially two or more sole proprietorships operating under a single entity. If two or more individuals begin working together in a business operation and have not formally formed a partnership, LLC or Corporation, by default, the business operation is regarded as a General Partnership.
Partnerships establish one General Partner and he or she has unlimited liability for the partnership. Conversely, a Limited Partner’s personal assets are at risk only to the extent of the Limited Partner’s investment in the business.
One of the major advantages of a partnership is that more owners often will result in more resources. Together, multiple owners can pool capital, skill sets, and networks to create an advantage as they operate their business.
Business Partnership Agreement
One of the largest risks associated with operating a business as a partnership is if a partner makes a serious mistake which has legal ramifications or otherwise no longer works amicably within the business relationship. For this reason, it’s very important to take the time to carefully draft and execute a partnership agreement to address important partner matters such as compensation, distributions, retirement, buy-sell arrangements, disability and other potential dispute-resolution methods.
Partnership Tax Treatment
Partnerships are required to file a federal tax return every year. And in most states, a similar tax return is often required. A Federal form 1065 is filed on behalf of the partnership and its partners. The income (or losses), certain deductions, and guaranteed payments paid to the partners from the partnership are passed through to the partners. Each partner receives a federal form 1065 K-1 that identifies the items of income and expenses which should be reported on the partner’s individual federal tax return.
Limited Liability Company or LLC Definition
An LLC offers the best of two worlds. It is taxed like a sole proprietorship yet it offers limited liability protections for its members, similar to those protections offered to shareholders of a corporation.
LLC owners are called members and they may use losses incurred by the LLC to offset income up to the total amount the owner has invested, but not more.
In the event the business runs into legal or financial trouble, the owner’s personal assets have more protection than those of a sole proprietorship – however that protection is limited.
And LLCs may be subject to additional state and/or franchise taxes separate from its member/owners.
Limited Liability Company Advantages
If you’re contemplating the formation of an LLC over a sole proprietorship, note the LLC will offer you more personal liability protection and be perceived by customers, vendors, employees, and others as an established business operation.
In addition, LLCs are simpler to form than a Corporation and generally cost less to operate from an administrative perspective. LLCs also offer members much flexibility regarding how profits and losses are shared between members and how distributions may be made.
Limited Liability Company Operating Agreement
One of the key steps a business owner should take when forming an LLC (either as a single-member LLC or as a multi-member LLC, is the development of an Operating Agreement for its member(s).
The LLC Operating Agreement should spell out clearly what is expected of members, which members have what roles and responsibilities, how profits and losses will be shared, how and when distributions may be made, and how ownership may be bought or sold in the future, among other important matters.
Limited Liability Company Tax Treatment
LLCs are taxed on their profits for federal tax purposes in one of several ways:
- By default, a single member LLC is treated as a sole proprietorship and if it has multiple members, the LLC is treated as a partnership; and alternatively
- If elected separately, the LLC may choose to be treated as a C Corporation, or as an S Corporation for federal tax purposes.
Most states automatically recognize the same tax treatment or any alternative elections, however it’s wise to verify this with the state in which your Limited Liability Company is formed and/or conducts its business.
Corporation Definition
A corporation is a separate legal and taxable entity, which is independent from its owners who are called shareholders.
Because the business is treated as a separate legal entity, there is less risk to the owner’s personal assets. Corporations may have one or many shareholders, all of whom have the right to profits through dividends in the form of cash and/or additional shares of stock, but who are not held personally liable for the business’s debts and legal issues.
If you have (or plan to have) more than one business under your ownership, read more about how multiple business structures can face different tax consequences here.
Corporation Formalities
One of the biggest differences between a corporate structure and all other forms of business structures is the formalities the officers and directors must maintain to retain the corporation’s independent, or separate legal status from its shareholders.
Such formalities start when the business is formed. A corporation must file formal Articles of Incorporation, hold a meeting of its shareholders to authorize the formation of the business entity, issue shares of stock (certificates) to its shareholders, publish a formation notice in one or more legal journals, to name a few.
Any time a decision is made by the corporation’s Board of Directors or Officers, such a decision must be voted upon, approved, and recorded in the Corporate Minutes. And everything must be entered into the corporation’s books and records.
Holding an Annual Meeting of the Shareholders is also a requirement and so is the documentation of any decisions made at the meeting.
Corporation Taxation
By default a corporation is treated for federal tax purposes under U.S. Title 26; Subtitle A; Chapter 1; Subchapter C (the C Corp).
C Corporations are taxed solely on their income and the business’s income and losses are not reported on the owner’s personal tax returns. A federal tax form 1120 is filed by the corporation each year.
Distribution of corporate dividends received by the shareholders of a corporation are taxable at the federal level and in most cases at the state level.
If by election, the shareholders of a corporation choose to elect Subchapter S federal tax treatment, then the income, expenses and certain other tax credits will not be taxed at the corporation’s level. Instead, they pass-through to the shareholders according to their respective ownership percentage and each shareholder reports these on their personal tax returns.
When a corporation has elected Subchapter S tax treatment, then a federal form 1120S is filed by the corporation each year and each shareholder receives a federal schedule K-1 to report his/her pro-rata share of the business income on their personal tax return.
Each state has its own rules with regard to how C Corporations and S Corporations are treated for tax purposes. In some states, additional franchise taxes are also paid by corporations, regardless of their federal tax status.
Other Various Business Types and Structures
Benefit Corporation
Benefit Corporations are relatively new in the United States and are not recognized in all states. It is a for-profit business entity (which means it pays income taxes on its profit) while its purpose must have a positive impact on society and/or the environment.
Limited Liability Partnership – LLP
LLPs are similar to a Professional Corporation as they are suitable for those employee-owners who provide certain services. The underlying business entity in the case of the LLP is a partnership and not a corporation.
Non-Profit Entity
A non-profit entity is not a separate business entity at all. Instead, it is a corporation which has applied for and obtained permission from the Internal Revenue Service to be treated under one of the non-profit tax codes. This designation as a non-profit by the IRS is only awarded after a lengthy application and vetting process. Upon its award, the corporation is no longer subject to federal income taxes.
Professional Corporation – P.C.
When employee-owners provide personal services in the fields of accounting, actuarial science, architecture, consulting, engineering, health, veterinary, law, and the performing arts, the corporation is considered to be a Professional Corporation and is subject to specific tax rules which differ from the rules applicable to C Corporations and S Corporations.
Professional Limited Liability Company – PLLC
Similar to a Professional Corporation, the PLLC may be used when employee-owners provide certain personal services under a Limited Liability Company entity structure.
Series LLC
Certain states permit a single LLC to be formed and to serve as the master of a series of LLCs. Each LLC in the series is called a cell.
For those states which offer this form of multiple business structure, the LLC cells held in the series are considered to be a single entity from a legal perspective.
This form of multiple LLC structure is relatively new and is not recognized in all states. Recently, the IRS has been attempting to simplify the taxation of Series LLCs. With that said, caution should prevail as there is little case law supporting the limitation of liability when a Series LLC’s business operations cross state lines.
You may read more in Part Two in this Series about How to Structure Multiple Businesses Under a Single Business Entity.
Holly Magister, CPA, CFP
Holly also founded ExitPromise.com and to date has answered more than 2,000 questions asked by business owners about starting, growing and selling a business.
Latest posts by Holly Magister, CPA, CFP
- Understanding the Business Buyer Types When Selling Your Business - April 12, 2019
- How to Prepare and Include the Business Owner’s Family in the Exit Planning Process - March 14, 2019
- How to Prepare for Due Diligence When Selling a Business - February 12, 2019
Great info I couldn’t get anywhere in NC or from IRS!
I have an S Corp for my Real Estate Company (1 person now that I am semi-retired) called Wilmington Real Estate 4 U, Inc. I am starting a Travel and Lifestyle blog and will be incorporating the real estate company piece as an affiliate by offering information and tips on purchasing property in areas where you travel. In other words, in addtion to travel I will talk about investing in real estate. We operate in NC under the Corporate name, but do I just get a DBA for the Blog or a DBA for both? Thank you
Hi Sandy,
This is a great question as many business owners create something like a blog (or another related product/service) with a name which differs from their business’ official name and can get into trouble.
We’ve got another post on the topic of Intellectual Property which covers the various types of IP protection you should consider.
Hope it is helpful to you Sandy…
Holly thank you for all the wonderful information you give. I have a quick question or two about the proper way to set up an entity. A good friend and I have full time jobs and we are planning on opening a swimming pool service in NJ. What do you think the best way to go would be? We are going to pay ourselves an hourly rate as if we are employees. With that being said would it be better to 1099 ourselves or withhold the taxes? Any help would be greatly appreciated. Thank you for your time and your work.
Hi Alan,
Very sorry for the delayed response to your question! I was away for a few days and got a bit behind in my replies.
The way in which an owner of a business is compensated is determined by the type of business entity you choose to form.
If you form a partnership with your friend, you simply take out money from the partnership and it’s recorded on the books as a ‘guaranteed payment’ to the partner. When the partner files his/her personal income tax returns, the federal income taxes and payroll taxes are paid.
If you form a corporation, you must pay shareholders who perform services for the business via a paycheck and report the compensation on a Federal W-2 form at the end of the year.
There is no correct way to compensate a business owner by payment via a 1099. Federal Form 1099’s are used to report the payments made to independent contractors to a business.
Hope this helps you a bit Alan!
All the best…
When forming an LLC for a business that will operate virtually, I have read conflicting articles about how to file business paperwork.
I have read the best practice is to leverage USPS or UPS street address services (in addition to your P.O. Box since business filings do not accept a P.O. Box) however, when reviewing terms and conditions offered by USPS/UPS they reference not using the address provided by them on any business or legal documentation. I have not yet been able to get additional clarification on what circumstances would allow our business to use this address service vs having to use one of the members home addresses.
Any additional insight as to when and in what context this type of address provided by USPS/UPS can be used legally and correctly?
Hi Melissa,
I am not familiar with what you’ve read about ‘best practices’ related to using a USPS or UPS street address when forming an LLC.
It’s always been my understanding that when filing the application for a business entity, the states want on its records the official street or physical address where the business is operating or being managed. It doesn’t seem to me that using the physical address of a mailing service (USPS or UPS store) would be an address the state would accept.
This may be why the USPS and UPS terms and conditions prohibit its customers from using their respective physical addresses on official business or legal documents.
All the best…
Hello
I am getting ready to do my articles of incorporation for New York state and i was told there may be a fee for just having a corporation even if it doesnt make money is this true? I also am having trouble finding out if NY has a franchise tax and if there is a fee for the initial and annual reports? I also am trying to find out if i have a single member corporation and decide to pay myself as an employee will i then be required to pay unemployment insurance and social security and medicare tax and will i have to have workers comp insurance and am i required to have a registered agent or can i act as my own
Hi Yasmin,
In many states, corporations are subject to fees — sometimes it’s a one-time fee and in other cases it may be an ongoing fee even if the corporation is not profitable.
I am not familiar with NY State rules for such a scenario or if there are franchise taxes, fees, etc. You should consult with an Attorney in NY for assistance with this.
Here’s where you may request such assistance.
As for compensation through wages or salaries, that falls under federal employment rules and regulations. Any time you have an employee being paid wages, your business will be required to pay unemployment taxes (Federal and State), Social Security Taxes, Medicare, Worker’s Compensation Insurance premiums, etc.
When you form a business entity, you may act as your own registering agent if you wish to do so.
All the best…
Hi,
For the last 2 years I have been a GM for a rather large used car dealership owned by a childhood friend of mine. After my two attempts to buy in where unsuccessful, reason given “money wasn’t needed” I decided it was time to leave and go out on my own, upon giving my two weeks i was presented with an offer of partnership in my new location that i had recently acquired. The offer sounds great and makes a lot of sense because i immediately know the type of partner i’m receiving but more importantly the banks that i would immediately have access to to get my customers financing where priceless, and would take me years to establish on my own and even than they are not guaranteed.
The only caveat is that in order for the banks to flow to my organization and be recognized immediately, i would need to essence become a sateletie store under his current organization.. In order to do that a DBA has been drawn up, now that DBA is a Inc which we co own and are both on the articles of incoparation.. however it is a DBA under his existing company..
my question to you is am i protected as an owner as we have an articles of incorporation for the business DBA.
also this is a 50/50 partnership where we will be splitting 50/50 of the profits and expenses with plans to open up additional locations under the new DBA as basically a sister store the exiting business..
Can you please explain to me what if any protections i have and what if any legal documents i should have in order to protect my investments and future business..
Hi Peter,
I strongly recommend you speak with an Attorney to represent you as you take steps to co-own a business with your employer.
That said, you have an exciting opportunity as you have proven your abilities and you have a good relationship with your employer/owner.
It sounds to me that a new corporation was formed for the new location and the corporation is filing for a fictitious name (DBA). If so, and you are going to own 50% of the shares of the new location, it would be very wise to have a buy-sell agreement drawn up between you and your co-shareholders. Drafting the terms of a buy-sell agreement before any disputes may arise is extremely important.
Here’s where you may request help from an Attorney to help you if you do not have legal counsel already.
All the best Peter!
Hi,
I’ve read the NY requires “foreign LLCs ” to register, in essence go through the same process as if they were a new LLC, i.e. pay the state registration fees, publish this “new formation”, etc. Recently I was told that rule is specifically created for LLCs that collect sales tax.
I found this article: https://www.nolo.com/legal-encyclopedia/how-qualify-foreign-business-new-york.html
Can you help clarify this for me? thanks so much.
Hi Jay,
I am not sure what you are asking me Jay… that said, I will try to address what’s typically confusing when it comes to doing business in another state outside the state in which your business was formed:
1. If your business was formed in one state, it is a domestic entity in that state. Whereas, if your business was formed in one business and transacts business in another state, it is considered to be a foreign entity in the ‘other state’ and may require filing as a foreign entity.
2. What exactly makes up ‘transacting business’ in any given state varies widely so you have to consider every state’s rules on this matter. That’s not a good situation if your business is doing business all over the U.S.!
3. Most states are very clear about what constitutes whether a business has a presence in a state — the term is called ‘nexus’ and is used in many state’s laws on this topic. Some of the factors that states rely on, such as employees working in the state, sales reps making sales calls in the state, inventory sitting in the state, and/or having an office or meeting place located in the state, will almost always establish nexus.
4. When nexus is established in another state by a business (even if you have not registered your business in the state as a foreign entity), the collection of sales tax is going to be required. And of course every state has it’s own set of rules about what is taxable and what is not taxable for sales tax purposes!
5. When nexus is established in another state by a business, it also may be subject to corporate income tax reporting and payment to this state.
As you can see, it’s very confusing and truly should be carefully considered by you and your CPA every year so you are not out of compliance — especially important if you ever sell your business. And that’s because the buyer of your business will examine the nexus issue, relative to your customer base/sales and other factors present in your business, before they buy your business. If you are out of compliance, it is very likely you will be indemnifying them for this potential unknown liability. That is never a good situation!
Hope this sheds some light on this for you Jay!
All the best…
I have a complicated one –
My wife and I are setting up a farm. On this farm we will sell grass finished beef & lamb.
Florida law states that because the feds require the animals be slaughtered and processed in a federally certified facility I am only a “middle man” and can sell this meat on-line.
I also enjoy making cheese and when the beef/lamb operation is up and running I would like to take the “trim” and make sausage and render tallow & lard for sale as well.
We were thinking that a LLC would be best way to go for the ranch & we could include our kids on that so there would be no probate.
Here’s the thing :
I can sell aged cheese, sausage and tallow, in Florida, but only as a “cottage industry” that earns under $50,000/year
Do we want multiple LLCs?
One for the cattle, which makes more than the limit and will not be a cottage industry.
One for the dairy, which uses unpasteurized milk for the cheese and is bound to get sued.
And one for the rest.
If so, THEN the big question – Can they all sell off the same website, in essence, act as one company with multiple names? Ans do we have to disclose that we are one “group”?
Hi Larry,
Using a separate business entity, such as an LLC, and being sure to respect it’s boundaries by treating each LLC as its own entity is a first, good step to protecting you and your family and each business.
If you do choose to form the multiple LLCs, there’s no reason why you can’t market each LLC’s respective products from a single website. If you are using a URL (website domain name) that is not one of your LLC’s official names, then you should file for a fictitious name or DBA.
It would be wise to disclose in the site’s terms and conditions the business entity(s) which are tied to the site.
Hope this helps a bit.
All the best…
Hi I have a question. Currently I have daycares, all under different LLC but same name, I just add II, III …etc…so the question I have how can I keep just the name for promotion & marketing & logo with out having to incorporate the name under an umbrella. If I do so I’m running the risk of worst case scenario for all my other schools to be liable Incase of a law Suit, correct? I’m trying a way to expand without having to add numeric #
Thank you
Hi Sasha,
If you’ve formed a Limited Liability Company for each of your daycare locations, then you’ve taken the first step to separate each operation and have limited the liability exposures between the operations and you as an individual. That’s a good first step.
If you want to use the same trade name (without the appended numeral) for marketing and logo across all of your locations, you could do so by filing for a service mark and licensing the mark to each operation. Each operating LLC would also need to file for a fictitious name to use the service marks.
If you want to add new locations, filing for a separate LLC (with the numerical extension) is still wise to do.
You should consider consulting with an Attorney licensed to work in your state as you work through these matters. We’re happy to introduce you to such an advisor here.
All the best…
Holly – –
Wow! The advice and input you are giving is invaluable. As a community minded successful business woman I want to just say: THANK YOU first. It is impressive, smart and shows a commitment to entrepreneurialism.
Quickly. I have sold an existing business under my S Corp. I have 3 vacation rentals in a commercial building that I own that is an LLC and currently these rentals are operating under the LLC. I am wanting to dba these rentals as one business (with a business name) under my S Corp now that my previous business has been sold. My goal? To remove the vacation rentals from the LLC to provide an extra wall of protection for myself by thus creating a business that is vacation rentals.
My previous business ran under the SCorp so I understand the tax implications. My question? Is grouping my 3 vacation rentals in this fashion a “business”, and one that can be dba under an S Corp?
Thank you.
Christine
Hi Christine,
Thank you for your kind words! Much appreciated…
If you have a Limited Liability Company which owns the commercial building which is operating vacation rentals, you already have a business. In other words, the vacation rentals units, owned by the LLC, is a business.
So, it’s not really clear to me what you are trying to do.
Do you want the taxation of the LLC to be as if it were an S Corporation? If so, such an election may be made.
Or do you want the S Corporation to own the commercial property and/or the vacation rental operations?