Tax Series #13: Types of Business Structures for Small Businesses

Hello everyone,

I have worked with many small business operators with their accounting and taxes, and one of the most common questions that I get is, "which type of business structure is the best choice when incorporating a small business?" So if you are thinking about starting a business, this article could help guide you in the right direction.

First and foremost, the decision to choose the right business entity is dependent on your situation. It is also a decision that should not be taken lightly. This is because the business structure that you choose will have both tax and legal ramifications as long as you keep that structure. So let’s go through each one and analyze the details.

1. Sole Proprietorship: this is the most basic type of business structure where it is extremely simple to set up. There is no state filing required, and minimal paperwork to submit. You are the company, and company profits and losses are reported on the owner’s personal tax return. However, the owner is personally liable for business debts and legal liability of the company. If you feel that the nature of your business may carry substantial legal liability that cannot be managed via a general umbrella insurance policy, then this type of business structure may not be for you.

2. Partnership: this is much like a sole proprietorship, where a group of individuals set up a joint company. There is minimal paperwork involved in setting up the incorporation, and most states do not have filing requirements. Also, the partnership’s profits and losses are ‘passed through’ the entity to the partners’ personal tax returns, and are taxed once at the individual tax level. However, the partners are personally liable for debts and legal liability of the business.

3. C Corporation: if you want limited liability protection where you will not be held personally responsible for the debts, obligations, and other legal liability of the company, then setting up a C-Corporation might be a good idea. Also, this form of incorporation provides maximum flexibility in terms of business management, ownership transfer, and types of stocks/equity that can be issued. However, there are some drawbacks. First, there is double taxation, where the company pays a corporate tax, and any left-over income that is distributed to stockholders in the form of dividends get taxed at the individual tax return level. Second, setting up a C-Corp takes a lot of paperwork, and there are ongoing requirements such as generating periodic financial statements, holding annual meetings, and taking meeting minutes. But there is another option…

4. S Corporation: S-Corp blends the best of both worlds, where you get the limited liability protection of a C-Corp, but gets single-taxation treatment (much like a partnership). However, in order to qualify for the S-Corp status, you must meet certain conditions. Main conditions are:

   • company can only issue one type of stock (cannot have preferred stock)
   • company can have no more than 100 stockholders
   • all stockholders must be either U.S. citizens or residents
   • no partnerships, C-corporations, and certain financial services companies can be owners of an S-Corp

5. LLC Limited Liability Company: this is a relatively new form of incorporation and is similar to an S-Corp, in the way of limited liability protection for member owners as well as single taxation via the pass-through mechanism. However, it could be considered more flexible than an S-Corp. Flexibilities include:

   • LLCs can have unlimited number of shareholders
   • Non-U.S. citizens/residents can be member owners of an LLC
   • LLCs are allowed to have subsidiaries without any limitations (unlike the S-Corp)
   • less ongoing requirements versus an S-Corp, where S-Corp is required to adopt bylaws, hold annual director and shareholder meetings, etc.

I hope that this deep dive helped you to understand more about the different types of business structures and the tax implications of each. These matters can be a bit complex in language and tax effects, so if you have a particular situation that you have questions about, please reply and I would be happy to help. Thanks for reading!

If you like my tax series, check out my previous posts below:

Tax Series #12: Itemized Deductions

Tax Series #11: Beware of Tax Identity Theft

Tax Series #10: Child Tax Credit

Tax Series #9: Standard Deduction vs. Itemized Deduction

If you are interested in learning more about personal finance, check out these posts:

Personal Finance Series #11: Finance Tips for Newlyweds

Personal Finance Series #10: Financial Habits of the Wealthy

About the Author : I am a cryptocurrency enthusiast and a U.S. Certified Public Accountant with over 16 years of experience in accounting, taxation, and finance.

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