Picking the Right Corporate Structure for Your Business
If you decide to do business without creating a specific organizational structure, you are essentially operating as a sole proprietorship. Many sole proprietors choose to file a DBA ("Do Business As"), which lets them legally transact business through a business name of their choice ("Flowers By Mary") rather than their personal legal name ("Mary Smith").
Business owners who feel they are at low legal risk and want to avoid the hassle of setting up, registering and maintaining a formal business entity.
Because the owner and the business are considered one and the same for legal purposes, you can be held personally liable for the debts and obligations of the business.
Any net income you earn from the business is fully taxable at the same tax rates as wages or retirement income. You may be eligible for the Qualified Business Income deduction, which allows you to exclude up to 20% of the business income from tax.
Income from a sole proprietorship is reported on Schedule C, Profit or Loss From Business and included in your personal tax return. There is no separate return to file, making the tax reporting relatively simple.
Raising money can be a challenge: There is no company stock to sell, and banks may be reluctant to lend to sole proprietors. Because sole proprietors are not registered with the state or IRS, you might also have a hard time building credit. Plus some sole proprietors have difficulty establishing boundaries between their personal finances and their business finances.
C Corporation / C Corp
A C corporation, usually shortened to C corp, is the exact opposite of a sole proprietorship. It’s a legal entity that’s separate from its owner and can have multiple owners (or shareholders), elect directors, write bylaws and appoint officers that run the company. It pays its own taxes but also provides the highest level of liability protection.
Corporations can be a good choice for medium- or high-risk businesses as well as those that need to raise money. If you want to be in a position to someday sell your business — or go public! — a C corp might be your best choice. As the owner, you also give up some degree of control to the board of directors, which will be responsible for all the company’s major decisions.
While corporations can get sued, the owner’s personal assets are typically not at risk. Most publicly traded businesses are C corps, and the maximum loss a shareholder can incur is what they paid for their stock.
C corps are typically the least tax-efficient form of business. A C corp pays tax on the net income earned by the business at a flat 21% tax rate. While that may seem low compared to the top individual tax rate of 37%, that income is trapped inside the business – when the remaining 79% of its income is distributed to the owners as a dividend, it’s taxed again at a rate as high as 23.8%. In other words, C corp income is taxed twice, at an effective rate that can reach nearly 40%.
A C corp files its own tax return using Form 1120. Its income has no impact on the owner’s personal tax liability, unless that income is passed out to owners as a dividend.
Forming a corporation costs more than it does other business entities, and corporations tend to require more extensive record-keeping, operational processes and financial reporting. On the other hand, C corps are ideal for businesses that plan to have an unlimited number of owners, transfer shares easily and reinvest profits back into the business.
S Corporation / S Corp
An S corporation is a unique form of entity that combines many of the best aspects of both a sole proprietorship and a C corporation. While there are restrictions on ownership and other issues, many business owners appreciate S corps’s liability protection and tax efficiency.
S corporations are for business owners who want the liability protection of the corporate business structure but also a single level of tax on business income. S corps typically allow for greater flexibility in their accounting methods than C corporations.
S corps are designed to provide owners a higher level of personal liability protection, just like C corps. An owner’s personal liability is generally limited to their investment in the S corp stock.
An S corp is considered a “pass through” entity, meaning it doesn’t pay any tax itself. Instead, each owner reports their share of the business’s income on their own personal return. As a result, this entity avoids the double-taxation of a C corp. In addition, you may also be able to take advantage of the Qualified Business Income deduction, just like a sole proprietor.
An S corp files its own tax return, using Form 1120-S. However, because the business doesn’t pay any tax itself, it issues a report to each owner (called a Schedule K-1) that lists their share of the business’s income. You must wait to file your own return until you receive your K-1 so you know how much business income to report.
S corporations are very limited in the number and types of owners they can have, so entities with many owners may not be eligible to elect S treatment. However, S corps provide a bit more flexible structure than C corporations while avoiding double-taxation, so these structures are relatively popular among business owners.
Limited Liability Company
Limited liability companies, or LLCs, actually are entities created under laws determined by individual states, though the rules are largely uniform. They typically are easy to create and manage and offer owners great flexibility.
An LLC is good for any business owner looking for a more informal structure but still concerned about protecting personal assets from business liabilities.
While an LLC can be useful in protecting your personal assets from the actions of an employee or a co-owner, an LLC owned by just one person (a “single-member” LLC) offers only limited protection from their own business decisions.
One of the great flexibilities of an LLC is that the entity elects how it chooses to be taxed. Single-member LLCs default to sole proprietorship treatment, meaning the income is taxed directly to you. However, LLCs can also be taxed as a C corporation and pay the flat 21% tax, though more typically they would then elect S corporation treatment. Whatever the tax treatment, the liability protections of the LLC remain the same.
The LLC will report its income according to the tax structure it elects. If it’s a sole proprietor, the owner will file a Schedule C. If it elects corporate tax treatment, it will file a separate return and either pay tax itself or pass the income through to the owner. If it elects sole proprietorship or S corp status, the income may be eligible for the Qualified Business Income deduction as well.
From a reputational standpoint, establishing an LLC tends to give you more credibility with customers as it signals you intend to be around a while. You might also have an easier time raising capital and have more flexibility in how you structure and run the business, share profits and keep your accounting records.
So which structure is right for you?
That will depend on several factors, including the kind of products or services you provide, how much flexibility you need in your business plan and your thoughts for growing your company in the coming years. Your Baird Financial Advisor can help you navigate the financial complexity that comes with starting up a new business.
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