Ownership and Legal Structure Options for Your Small Business
“Do I need to form an LLC?”
As a CPA, this is one of the most popular questions I receive when someone is just starting a small business.
It is also the subject of this post, where I dive into the various ownership and legal options available to you and your small business.
When it comes to defining your ownership and legal structure, there are two main questions to consider:
- Will your business have more than one owner?
- Will you adopt a legal structure other than the default prescribed by the Internal Revenue Service?
It is important to keep in mind that adopting a different legal structure, such as an LLC, does not necessarily change how your business is taxed.
A common misconception among new business owners is that forming an LLC will automatically help save on taxes, which is untrue.
Forming an LLC is much more about legal protection than it is about tax savings.
There are additional steps and strategies that can be implemented that can reduce tax as an LLC, which I address below, but adopting an LLC alone does not result in tax savings.
Read on for details on what should be considered related to ownership and adopting a legal structure.
In the simplest, most common form of business ownership and structure in the United States, the sole proprietorship, one person owns and operates the business.
If you are starting your small business yourself, will be running it yourself and do not need investors, there is likely no need to take on outside partners.
You can keep it simple and own 100% of your business.
However, even if you own 100% of the business, you have a few options regarding what legal structure you adopt.
While you are a sole proprietorship by default, which offers you no legal protection, you can file the necessary paperwork with the IRS and/or your state government and elect to be treated as an LLC or S-Corp.
You can read more about this later in this post.
More Than One Owner
The reasons for taking on partners in your small business are varied.
For example, you may have come up with the business idea with someone else, may need other people with a complimentary set of skills to help you run the business, or may need outside, equity investors.
The list of reasons for taking on partners could fill a book and your reasons will likely be unique.
However, if you have a partner (or multiple partners), your tax filing requirements immediately become a little more complicated, as you will need to file a separate business tax return for the business and report each owner’s share of the business’s profits (as a sole proprietor all of your business’s activity is reported on your individual return).
When more than one person owns your business you are treated as a general partnership by default, which, like a sole proprietorship, offers no legal protection.
You can file the necessary paperwork to adopt a different type of legal structure, which will provide you with additional legal protection if you deem it necessary.
There are lots of options when it comes to deciding how to legally structure your business in America.
Here, I touch on the most popular forms.
- One owner
- Report income on personal tax return
- Unlimited liability for business debts and legal obligations
- Simplest form of business
- More than one owner
- Report income on partnership tax return, which passes through to partners
- Unlimited liability for business debts and legal obligations for all partners
- Simplest form of partnership
- More than one owner
- Report income on partnership tax return, which passes through to partners
- Unlimited liability for general, managing partners
- Limited liability for limited, non-managing partners
If you are the only owner of your small business, you are classified as a sole proprietorship by default for legal and tax purposes.
All income and expenses are reported on a Schedule C on your individual income tax return.
You bare all legal risk for decisions made in your business.
If something happens in your business that leads to legal action, your personal assets are at risk.
Legal protection is often the main reason that you need to consider adopting a different form of legal structure.
If there is little to no legal risk involved in your business, operating as a sole proprietorship may suffice until you start making a healthy profit.
Later on in this post, I discuss implementing why adopting an LLC/S-Corp structure is a popular option that can save you a significant amount on taxes once you starting making a healthy profit with your small business.
If your business is owned by more than one person, you are classified as a general partnership by default for legal and tax purposes.
All income and expenses are reported on a separate partnership income tax return.
The purpose of a partnership tax return is to report and divide the income and expenses of the partnership based on the partnership agreement.
The partnership does not pay any income tax.
The profits or losses are distributed to each partner, which then get reported on the partners’ individual income tax return, where any income is taxed.
When you have partners, it is critical that you create a partnership agreement.
This can be as informal as a handshake or back of a napkin agreement on how profits and losses will be divided.
However, I strongly advise that you seek legal counsel to draft a formal partnership agreement.
You may be starting a business with a friend, family member, or someone else close to you and think an agreement is unnecessary.
But there a lots of reasons an agreement is important.
A standard partnership agreement doesn’t just define how profits and losses are distributed.
It will also lay out how much money each partner will contribute to the business, rules for admitting new partners, powers to borrow money, and the responsibilities of each partner, among other things.
You never know when having a formal agreement will be necessary, so if you are going to have partners you should make drafting an agreement a priority.
Legal protections afforded to you as a general partnership, the default classification, are similar to that of a sole proprietorship.
That is, there aren’t many.
Each partner in a general partnership is legally responsible for the debts and actions of the business.
Their personal assets are at risk if legal action is taken against the business, even if it is the result of something another partner or employee did.
You may consider creating a limited partnership to help remedy this issue.
In a limited partnership, each partner is classified as either a limited partner or a general partner.
Limited partners only risk the capital they contribute to the business.
General partners risk their personal assets.
At least one partner needs to be designated as a general partner in a limited partnership.
Typically, the general partner(s) is the one managing the business and limited partners are outside, passive investors.
Note: Whenever you are adopting a legal structure, especially when there are multiple partners involved, it is ideal to consult with an attorney.
In order to limit the legal exposure that exists for sole proprietorships, general partnerships, and limited partnerships, many small businesses elect to create an LLC or incorporate their business.
There are also potential tax savings in adopting some of these legal structures.
- Taxed just like a sole proprietorship or partnership
- Limited liability for all members
- Flexibility in allocating income and distributions
- All income for active members subject to self employment tax
- Separate entity for tax purposes, though income passes through to shareholders
- Limited liability for shareholders
- Less flexibility in specially allocating income and distributions
- Active shareholders paid a wage, potentially saving on self-employment tax
- Separate, taxable entity
- Limited liability for shareholders
- Profits distributed as dividends also get taxed on shareholders’ individual return
- No limit on number of shareholders
Limited Liability Company (LLC)
For small businesses that want to keep things relatively simple and flexible, but would like added legal protection, forming an LLC for their business is often the solution.
If you create an LLC for your business, by default, nothing changes in the way your business is taxed.
If you own 100% of the business, you are taxed just like you were a sole proprietorship.
In fact, the Internal Revenue Service labels you a “disregarded entity” for tax purposes.
If you are the only owner and don’t have employees, you do not need to set up payroll and accounting in your business should be relatively simple.
If your business has more than one owner, you will be treated as if you were a partnership for Federal tax purposes.
Nothing changes here.
And, again, if you have no employees, there is no need to set up payroll.
I mention payroll because, as you will read in my discussion on S-Corporations below, it is one of the differences between how an LLC and S-Corporation is taxed.
The biggest benefit for small businesses forming an LLC is the additional legal protection it provides for debts and other legal obligations.
Each state has its own rules when it comes to forming an LLC.
Therefore, if you have the resources, you should consult with an attorney.
However, in many cases you can form a single member LLC with limited assistance.
The other popular legal structure for American small businesses is the S-Corporation.
S-Corporations and LLCs are similar in many ways.
They offer similar legal protection for the business owner(s) and pass through profits and losses for Federal tax purposes.
The differences are in the details.
Some notable differences in how S-Corps are different from LLCs for tax purposes are:
- An S-Corp is always a separate entity for tax purposes and must file a separate tax return, even if you own 100% of the business. However, the S-Corp is not taxed at the Federal level or by most states, although some states do impose an entity level tax. The profits and losses are passed through just like on a Partnership return.
- If you manage the S-Corp, you will have to set up payroll and pay yourself a salary. In an LLC, owners are not paid a salary. Typically, all earnings from an LLC are subject to self-employment tax for active owners. S-Corporation owners only have to pay themselves a “reasonable” wage for the work they do, which is the only amount subject to self-employment tax (see an example of this in the LLC/S-Corp combo section below).
- S-Corporations offer less flexibility in dividing profits and cash distributions than partnerships when there are multiple owners.
- Debt taken out in your business’s name has materially different tax ramifications depending on whether you are an LLC or S-Corporation.
While this list is short, understanding it is important but may feel overwhelming to you, which is why I offer services to help answer questions you may have in this area.
If you consult with your own small business attorney or CPA, these are the types of considerations you want to discuss with them if you want to have a better understanding of why one type of legal structure might make sense for your small business compared to another.
A little later in this post, I also provide a detailed example of a popular strategy that many small business owners adopt that involves both the LLC and S-Corp Structure.
But first, the final popular form of legal structure in America is the C-Corporation.
Forming a C-Corporation is a third option for small business owners looking to protect themselves from legal liability.
However, most small businesses elect to go with either the LLC or S-Corporation structure for tax reasons.
Unlike an LLC or S-Corporation, a C-Corporation is a taxable entity.
Profits are taxed on a C-Corporation’s income tax return.
Then, any profits that are distributed to the C-Corporations’ shareholders are taxed again on the shareholder’s tax return.
This is referred to as double taxation and is the biggest reason small businesses avoid the C-Corporation structure.
Of course, there are still reasons that some small businesses will elect the C-Corporation structure.
If you think that your small business could someday grow into a large, public company, adopting the C-Corp structure from the start may make sense.
Most public companies are C-Corps because the S-Corporation option has limits on the number and type of shareholders.
These limitations are not imposed on C-Corporations.
Again, this decision should not be made alone.
Seek the assistance of a personal attorney or CPA for advice for your particular situation.
The LLC/S-Corp Combo
One popular strategy for a lot of small business owners is the LLC/S-Corp combo.
You can form an LLC for legal protection when you start your business because it is easier to form an LLC in most states and has fewer legal requirements compared to incorporating.
Once your business is making enough profits for this strategy to make sense, you can notify the IRS that you want to be taxed as an S-Corporation by filing one simple form.
This may make sense right away if you are profitable from the start or may not make sense until a few years down the road if your small business is a side hustle and it takes a while to make a more significant profit.
Generally, I suggest it makes sense to consider electing to be taxed as an S-Corp once your business is making over $40,000 or so.
Why do this?
The main reason is to save on self employment taxes.
As an LLC, you will pay self employment tax on all of your profits.
However, as an S-Corp you have to pay yourself a “reasonable wage” and only pay self employment tax on the wage you pay yourself.
The remaining profits are not subject to self-employment tax.
Self-employment tax is currently 15.3%, so adopting this strategy can save a significant amount of money.
Why wait until you are making at least $40,000 +/-?
Because, as I said, you have to pay yourself a reasonable wage, which is subject to self-employment tax.
There are also additional costs associated with adopting this strategy.
You’ll have to pay additional payroll processing fees, unemployment insurance (yes, you have to pay unemployment insurance for yourself!), and fees to file a separate tax return.
Electing to be taxed as an S-Corp for tax savings doesn’t usually begin to make sense until your business is profiting at least $40,000.
To really get an idea of how much this strategy can save, let’s look at an example:
- You own an small business and your share of taxable profits is $100,000.
- You will pay income tax on the entire $100,000 in both of the scenarios below.
As An LLC
- As an LLC you pay self-employment tax on all $100,000 of the profit.
- This equals approximately $15,300.
As an S-Corp
- As an S-Corp you need to pay yourself a “reasonable wage”.
- There is no concrete definition for what is “reasonable”, but generally you should estimate what you would pay someone else to do your job.
- In this scenario, if you paid yourself a $40,000 annual wage you would only pay about $6,100 in self-employment tax, a savings of over $9,000.
The decision on who will own your business and what form of legal structure you should adopt is unique to you.
Every situation requires its own analysis.
If you are starting small and own 100% of the business, operating as a sole proprietorship may suffice.
You may even elect to create an LLC on your own in this situation.
However, as I’ve mentioned several times in this post, once you add partners to the situation or your legal exposure increases, you should seek out a professional for advice on your particular situation.
How to legally structure your business is just one of the issues you have to address as a small business owner.