Choosing a Business Structure

What business structures do entrepreneurs have to choose from, and what are their pros and cons?

By Anthony Bucci, Assistant Editor On Dec 8, 2014

When starting a business, one of the first choices entrepreneurs need to make is the type of legal structure for their company. Owners must decide whether their company will be a sole proprietorship, partnership, limited liability company (LLC) or corporation. The type of structure entrepreneurs choose for their company depends on myriad factors including the type of business conducted, the number of owners or partners and the entity’s financial situation, among others. 

“When an owner selects a structure for his or her business, it is important to weigh the legal and tax options of each one, and which best fits his or her needs and the needs of the business,” says Paul Dougherty, a CPA and tax partner at EisnerAmper. “Not only will the choice have an impact on how much owners pay in taxes, it will affect the amount of paperwork the business is required to do, the personal liability it faces and its ability to raise money.”

In this article, New Jersey Business speaks with New Jersey CPAs to discuss the various business structures, while exploring the pros and cons of each.

Sole Proprietorship 

Sole proprietorships are one of the simplest forms of conducting business and are generally the easiest to form. Sole proprietorships are owned and operated by a single individual and all profits and losses accrued from it belong to the owner. By default, a self-employed individual operates under a sole proprietorship until a different structure is selected.

“If an entrepreneur wants to start a business with clients paying them directly, that would be a sole proprietorship,” says Chris Colyer, CPA and partner at Wiss & Company. “So, there is no entity formed and business is solely being conducted under the owner’s personal name.”

Forming a sole proprietorship is simple enough: One registers with the state and acquires any local permits necessary to operate.

Additionally, this structure “simplifies paperwork, management and tax reporting,” according to Joseph Fazio, CPA and partner at O’Connor Davies. “For tax reporting, any income that is earned through a sole proprietorship is considered personal income,” he says. “Entrepreneurs in this structure need to file a Schedule C with their personal 1040 return, and it is important to keep track of all of your business income and expenses. The owner only pays taxes on profits and is not subject to corporate taxes.”

Even though operating a sole proprietorship can be considered “easier,” there are some major caveats. Perhaps one of the most notable is the risk associated with unlimited personal liability. Because the owner is the business and the business is the owner, he or she is held accountable for any debts, obligations and legal liabilities of the company.

“The biggest downside of operating as a sole proprietor is the fact that personal assets are at risk,” says Scot Guempel, CPA and co-leader of KPMG’s tax mid-market practice. “Owners don’t have any corporate shell or protective device of any kind that is insulating them from the activities of their business. Yes, there is simplicity to it, but there is also that risk.”

Partnerships

If a business will be owned by two or more individuals, entrepreneurs may want to look into a partnership. There are two main types of partnerships; general partnerships and limited partnerships. In a general partnership, each partner shares any losses, profits and the management of the business. However, each partner is personally and equally liable for debts of the partnership while limited partners serve as investors only. Limited partners share in the profits of the business, but their losses are limited to only what they invest. Limited partners have no control over a company, are usually not involved in day-to-day operations, and do not have the same liability as general partners.

Besides being generally inexpensive and easy to form, one advantage of a partnership is the simple tax structure it enjoys, according to O’Connor Davies’ Fazio.

“A partnership does not pay tax on its income, but ‘passes through’ any losses or profits to individual partners,” he says. “A partnership has to file a tax Form 1065 to report its income and loss. Each partner reports their share of income and loss on Schedule K-1 of Form 1065.”

The downside of a partnership is that, like a sole proprietorship, there is unlimited liability. So, the same legal issues can persist. “For instance, if one partner does something wrong, then both partners can be sued and personal assets like a home or car are at risk, unless an entity is set up that will provide the legal protection,” Wiss’ Colyer says.

Corporation

Sometimes referred to as a C corporation, a corporation is the most common form of business, but is more expensive to form and has a more complex structure. A corporation is an independent entity separate from its shareholders, and requires more compliancy with regulations and taxes.

Benefits of a corporation include limited liability, meaning the corporation – not the shareholders – is held liable for the debts and actions of business. Additionally, corporations are able to raise more capital, due to the ability to sell stock in the company.

In a corporation, taxes are only paid by owners on corporate profits paid to them through salaries, bonuses and dividends. However, in some instances, corporations can be taxed twice, once on the company’s profits and again on any dividends paid to shareholders.

As an example, EisnerAmper’s Dougherty points to IBM. “IBM is a C corporation, so it pays taxes and then pays dividends to shareholders and the shareholders pay taxes on those dividends,” he says.

S Corporation

An S Corporation is similar to a corporation, in that business owners have limited liability in the company. However, S corporations generally do not pay income taxes, but rather, the business’ income or losses are ‘flowed through’ to shareholders.

“I see a lot of enterprises go into this area because they like the idea of having a corporate shell, but also the idea of the flow through treatment,” KPMG’s Guempel says. “S corporation owners also have limited personal liability as with a corporation, but do not have to pay a corporate tax, which is an advantage. However, some disadvantages of an S corporation are the number of regulations and requirements that must be upheld and the business can’t have more than 100 shareholders. So, there isn’t as much flexibility as there is with a corporation or an LLC.”

Limited Liability Company

An LLC is distinct and separate from its owners and is a hybrid of a corporation and a sole proprietorship or partnership. The owners of an LLC have limited liability like a corporation and are only taxed once, like a sole proprietorship or partnership. However, an LLC has a flexible tax structure, so owners can choose how they want to be taxed. Additionally, owners have to file for a “certificate of formation” with the Secretary of State in New Jersey.

“Owners of an LLC can decide whether they want to be taxed as a sole proprietorship, partnership, corporation or S corporation,” says Matt Barbieri, a partner at Wiss & Company. And, one of the most attractive features of an LLC is its limited liability protection. “Members of an LLC are liable for their own actions, but aren’t liable for the actions of others or of the entity,” he says. “This means that personal assets are protected with an LLC, but members are not necessarily shielded from wrongful acts of the entity.”

LLCs are, however, subject to self-employment tax contributions to Medicare and Social Security, and the entity’s entire net income is subject to tax. LLCs also have a limited life. Generally, when a member leaves the business or dies, the company is dissolved. Provisions in an operating agreement can prolong the life of an LLC.

“LLCs are a fairly new business structure in the last 10 to 15 years,” Colyer says. “When entrepreneurs come to us and are just starting a business, we generally suggest that LLCs are the way to go. It is one of the most flexible forms and easy to set up. Years ago, there were costs in setting up LLCs and corporations, but today – for a few hundred dollars – you can go online and start your own, so there really is not a compelling reason not to do so.”

Conclusion

These are just a handful of the pros and cons of each business structure, and there are a multitude of factors when selecting the proper one.  Unfortunately, there is no “cookie-cutter” type of approach and the situation and needs of each business varies.

“It all depends on the type of business,” O’Connor Davies’ Fazio concludes. “We have to talk about what the business owner or owners are doing, where they are doing business, the number of partners – whether the partners are in state, out of state or international – how formal they want the business to be, how important tax efficiency and liability is and what are the future plans of the company, etc. It can be extremely important, especially for a startup business, to choose the proper business structure from the get go, because sometimes it can be difficult to change without any tax implications. Entrepreneurs just need to talk with their advisors in order to find the structure that best fits their business’s needs.”

Related Articles: