An important decision you'll need to make is whether you want to go through the legal process of creating a business.
During the process of setting up your business, you can choose one of many different legal structures for your business. Some give you the option to have little to no legal or financial separation between your personal and business finances. Others create a legal organization (generally called an entity) that is, in most cases, legally and financially separate from you, the business owner.
Choosing a business structure
Many small business owners can choose between several options when creating a business entity. Some will merge your personal and business liability and finances, while others provide distinct separation between the two. The most common structures are:
- Sole proprietorship
- Limited liability company (LLC)
There are also nonprofit corporations, which may be an option if your business will benefit the public. Additionally, some states allow you to create B corporations, which are for-profit corporations that have a public good as part of their mission.
Each business structure has its advantages and disadvantages. The best option may depend on your personal financial situation and goals for the business.
Here is an overview of each of the common for-profit options, but there are many nuances to consider. It may be wise to consult an accountant and business attorney before choosing your business's structure.
If you run a business without creating a business entity, you automatically become a sole proprietor. For example, if you sell crafts online, walk dogs for extra income or work as a consultant, you may already have a sole proprietorship without even realizing it. In some states, if you and a spouse run a business together, it will still be considered a sole proprietorship.
A sole proprietorship can be one of the easiest types of business to run. You won't need to register the business with the state or federal government or file a separate business tax return. Instead, your business income and expenses get added to your individual tax return. Additionally, you can still hire employees and create a separate name for your business.
However, with a sole proprietorship, there's no legal separation between the business owner and the business. You are the business. As a result, you could be personally liable for every business expense, debt or lawsuit. It could also be difficult to borrow money or build business credit.
You can create a partnership if there are two or more people who own or run the business. There are different types of partnerships, including general partnerships (GPs), limited partnerships (LPs) and limited liability partnerships (LLPs).
A general partnership is similar to a sole proprietorship in that it offers simplicity and is the default if you start a business with someone else. GPs also don't separate the partners' personal money from the business or provide any liability protection.
Limited partnerships (LPs) are business entities that are owned by general partners (not to be confused with the general partnership mentioned above) and limited partners (LPs).
The general partners take an active role in running the company and are personally liable for the business. The limited partners invest in the business, don't take an active role in running the business and aren't personally liable for the business. LPs are more commonly used for estate planning and investing than small businesses. Another example is if you start a company and a wealthy friend lends you money to rent a space and buy supplies, you may be the general partner while your friend is the limited partner.
With a limited liability partnership (LLP), all of the owners (i.e., the partners) of the business entity won't be personally liable for the business but they can still help run the business. LLPs are commonly used by groups of professionals, such as attorneys or accountants. The LLP lets the group share communal costs, such as office space, while claiming their share of the business's profits or losses.
Corporations (C corps and S corps)
Even if you're running a small business, you can create a corporation. The process is called incorporation and when you incorporate a business, you will by default establish your business as a C corporation. Or, if you meet the requirements, you can file a form with the IRS and elect to have the company treated as an S corporation, which has distinct benefits (described below).
In either case, a corporation is a separate legal entity that can provide liability protection to the corporation's owners. Corporations are required to have three official positions:
- The corporation's owner(s), also called shareholder(s)
- The executives, such as the chief executive officer (CEO), who run the company
- The board of directors, appointed by the shareholders, who oversee the corporation
If you start a corporation on your own, you can take on all three roles and be the shareholder (owner), the CEO that runs the day-to-day business, and the head of the board of directors that runs annual meetings.
Even if you're the only board member, you may need to follow certain rules if you want to properly run your corporation as a separate legal entity. For example, you may need to hold annual meetings and take notes about what you decided during the meeting. Check with your local and state governments for additional information on these requirements.
Once you establish a corporation, you may also need to set up a payroll system so the corporation can pay you for the work you do as the CEO. If you simply transfer money from the corporate bank account to your personal bank account, you won't be paying a variety of state and local taxes. You'll likely need to pay for a payroll system, and doing payroll (using the system to pay your wages and the company's taxes) can add to the complexity of running a small business.
C corporations and S corporations have all these things in common, but there are also differences to consider. One difference is how each type of corporation pays federal income taxes.
A C corporation must file a corporate tax return and pay federal income taxes on the money it makes after expenses — its profit. The wages it pays to the CEO (which could be you) are a business expense that won't be included in the profits. However, if there's extra money left over after all the expenses, the money could either be left in the company's account to spend on future expenses or paid to the shareholders.
Remember, the shareholders legally own the corporation, and you're a shareholder. You can't use the corporation's profits for your personal expenses, because the money legally belongs to the corporation, a separate legal entity. But the corporation can pay shareholders by issuing a payment, called a dividend, for each share a person owns.
However, this can lead to "double taxation." The corporation pays income taxes on its profits, the profits get distributed as dividends and then you pay individual income taxes on the income from your dividend.
Rather than creating a C corp, you could create a corporation and elect for S corporation status that allows you to avoid double taxation. S corporations don't have to pay corporate federal income tax. Instead, all their profits must be passed through to the shareholders each year and reported on the shareholders' individual tax returns. If you're the only shareholder, all the S corp's profits and losses get passed on to you.
This is why S corps, along with sole proprietorships, partnerships and some LLCs, are called "pass-through entities." All these types of businesses pass their income through to the business owners. Only C corporations pay corporate income taxes.
There are a few other differences between C corps and S corps that may be important to consider. For example, S corps can only have 100 or fewer shareholders. If you want to raise money from a large group of investors, that might not be possible with an S corp.
C corporations can be owned by an unlimited number of shareholders, which could make a C corp a better option if you dream of growing your company and listing it on the stock market.
Limited liability companies
Another option is to create a limited liability company (LLC). As the name implies, an LLC can limit the owners' personal liability. An LLC's owners are called members, and the LLC is an independent business entity.
An LLC can give you the protection that a corporation offers along with the flexibility and ease of running your business without corporate formalities. For example, you won't necessarily have to hold annual meetings and keep meeting minutes.
You can also choose how you want your LLC to be taxed.
Single-member LLCs (when you, and possibly your spouse, are the only owners) and multi-member LLCs can be taxed similarly to sole proprietorships and partnerships, respectively. The LLC's income and losses pass through to the members and are reported on their individual tax returns. However, you may need to pay state taxes or fees that are required for sole proprietors or general partnerships.
Or, you could choose to have your LLC taxed as either a C corp or an S corp. If you do, the same C corp or S corp tax rules apply. While this can add payroll requirements and the possibility of double taxation (with a C corp election), it may lead to paying less in taxes overall. However, even if you choose to be taxed as a corporation, if you created the business entity as an LLC, it could be more difficult to raise money from others because you can't sell stock in the company.