One of the first tough issues every business owner faces is choosing the right legal entity for your business.
There’s a ton of information about this topic online but, to cut to the chase, the vast majority of small businesses operate as sole proprietorships, S corps, or LLCs. We call these entities "the big three,” and here’s a quick overview of how they work:
1. Sole Proprietor
A sole proprietorship allows you to go into business for yourself, plain and simple. This is far and away the easiest type of business to own and operate, and you report all income and expenses on your personal tax return (Schedule C, to be exact).
The biggest drawback of sole proprietorships is that they don’t provide legal protection like corporations and LLCs do. However, if you’re a freelancer or one-person company and you’re in an industry that doesn’t involve much legal risk, then a sole proprietorship is the simplest way to go.
Easy to form and operate.
No corporate tax return required.
No legal protection — the owner is personally responsible for all liabilities of the business.
A sole proprietorship can have only one owner — any more than that and you’ll need to form a corporation, LLC, or partnership.
2. S Corp
A corporation is a separate legal entity that provides its owners (called “shareholders”) with substantial protection against legal claims. This is often referred to as “the corporate shield.”
In layman's terms, there are two types of corporations: S corps and C corps. While they function similarly in a broad legal sense, they’re completely different in terms of the type of ownership they allow and the way they pay taxes. Overall, S corps are the go-to choice for smaller, privately-held businesses that have one owner or a small number of shareholders. In contrast, C corps are the preferred choice for larger companies that plan to have lots of shareholders and multiple classes of stock.
From an accounting perspective, the biggest difference between the two is that S corps pay far lower taxes than C corps because they're classified as "pass-through entities" by the IRS. This means that all profits and losses from an S corp pass directly through to the owners’ personal tax returns, and the business itself doesn’t pay significant corporate taxes. And that, in a nutshell, is why most small businesses choose to be S corps.
Legal protection for owners/shareholders.
S corps are pass-through entities and don't pay corporate taxes.
Administrative burden (articles, bylaws, etc.).
S corps have specific ownership restrictions (maximum of 100 shareholders, all shareholders must be U.S. citizens, only one class of stock is allowed).
3. Limited Liability Company (LLC)
LLCs are a popular choice for small businesses because they provide the same major benefits as S corps — legal protection and minimal corporate taxes — and are easy to form and operate. In addition, LLCs provide greater flexibility than S corps in how profits can be allocated among owners. For this reason, LLCs are sometimes described as a cross between a corporation and a partnership.
On the downside, the legal rules surrounding LLCs are not as well-established as those surrounding corporations. Therefore, an LLC probably won’t be the best choice if you plan to operate in multiple states or sell stock to investors.
Legal protection for owners/members.
Pass-through entity (no corporate taxes).
Easier to administer than S corps.
Legal treatment varies from state to state.
Because they cannot issue stock, LLCs are not viewed as “investment-ready.”
Legal stuff: This information is for educational purposes only and does not constitute advice for your specific situation.