Business Structure Overview

Business Structure Overview

When you form your company, you first file with the state in which you are forming the company. It is here that you designate it as a sole proprietorship, partnership, corporation, or LLC (see IRS Form 8832). You then file paperwork with the IRS to determine your tax classification (sole proprietorship or C corporation). If you would like to form an S corporation, you have to apply to the IRS.

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Checklists for how to form an S corporation, an LLC, and a sole proprietorship.

Sole Proprietorship

Pros

  • Taxed at personal not corporate income tax rate.

  • No corporate tax.

  • No double taxation.

  • Less red tape setting up & running a business.

Cons

  • Personal assets are not protected from business debts and lawsuits.

  • Pay and report taxes as self-employed (Schedule C).

  • Pay self-employment tax (which is calculated as % of company profits, not salary).

For purposes of this article, we will assume that you are forming a sole proprietorship, not a partnership (but the rules, benefits, and drawbacks that apply to sole proprietorships also apply to partnerships).

 

Organizing your ESD business as a sole proprietorship is probably the easiest and least expensive path to take in terms of setup and ongoing regulations and fees. However, it could go either way on taxes, and there are risks.

The biggest drawback to operating as a sole proprietorship is that your personal assets are not protected from business creditors and lawsuits. This is because, as mentioned above, you and your business are not separate entities, legally speaking.

Whether it’s more or less expensive to operate a sole proprietorship or LLC depends on your personal finances because, as a sole proprietor, your ESD business revenue will pass through to your personal income tax return. This has advantages and disadvantages.

On the upside, you will be taxed at a personal rather than a corporate income tax rate, and your business will not be subject to a corporate tax. This means that you will avoid “double taxation” (see Terms chart, below, for an explanation of “double taxation”). And if you are trying to avoid red tape and regulatory fees, organizing your ESD business as a sole proprietorship could be the way to go. There is going to be less paperwork involved in setting up your ESD business, and going forward, sole proprietorships (and partnerships) are less regulated than S corporations and LLCs. For example, there is no requirement to have a board of directors, let alone board-approved bylaws or annual meetings and minutes. In addition, fees to set up and run sole proprietorships are lower than for S corporations and LLCs, and your business’s accounting may be more straightforward and therefore more affordable.

On the downside, you will have to pay taxes as self-employed (using Schedule C) which means reporting business income and expenses on your personal tax returns. It also means that you will have to pay the more expensive self-employment taxes (100% of Social Security and Medicare) rather than FICA taxes (50% of Social Security and Medicare). In addition, your self-employment tax rate will be calculated as percentage of your business’s profits (up to $142,800 in 2021) rather than as a percentage of your salary alone. Depending on your salary, this can also cost you.

If you decide to organize as a sole proprietorship, we recommend that you create a DBA (DBA stands for “doing business as”). It is very easy to do, just file a form (i.e., fictitious business name statement) with your county or state. When choosing a name for your ESD business, ensure that the name you prefer is not already taken by running a search on both your county (i.e., county registrar office) and state (i.e., secretary of state) websites.

Sole proprietorships file using IRS Form 1040 with Schedule C and partnerships file using IRS Form 1065 with Schedule K-1 for each partner.

Limited Liability Companies (LLCs)

Pros

  • Taxed at personal not corporate income tax rate.

  • No corporate tax or double-taxation.

  • Less red tape setting up & running a business.

  • Personal assets are not protected from business debts and lawsuits.

Cons

  • More fees to set up and run.

  • Pay and report taxes as self-employed (Schedule C).

  • Pay self-employment tax (which is calculated as % of company profits, not salary).

When you first form an LLC, it is by default a sole proprietorship or partnership—it won’t become a corporation unless you also incorporate. For purposes of this article, we are assuming that you will not incorporate your LLC (but, if you do, the rules of S or C corporations will apply).

The benefits of an LLC include providing a formal business structure for your ESD practice and being easier to establish and run than a corporation (for instance, it’s only suggested, not required, that you hold annual meetings and adopt bylaws). In terms of finance, company revenue passes through to your personal tax returns, so you are taxed at a personal rather than corporate tax rate. And because there is no corporate income tax, there is no “double taxation.” And unlike a sole proprietorship, an LLC will protect your personal assets from business creditors and lawsuit awards as long as you keep personal and company finances separate.

The disadvantage of forming an LLC is that it will be taxed as a sole proprietorship. This means that you will pay taxes as self-employed and report your ESD business’s income and expenses on personal tax returns. As noted in the sole proprietorship section above, you will pay full self-employment rather than FICA taxes (see Terms chart, below), and your self-employment tax rate will be calculated as a percentage of company profits (up to $142,800 in 2021) rather than as a percentage of your personal salary alone. On top of that, while LLCs are easier to set up and run than corporations, they can be more costly. For instance, in addition to the setup fees, your LLC will have to pay recurring fees, like the fee to file your annual report. It is also more difficult to attract outside investors as an unincorporated LLC than as a corporation.

Note that each state has its own tax rules, and some states tax the LLC as well as the owner (sometime in the form of a franchise fee).

Bottom line—if you don’t want to incorporate but you do want some of the liability and asset protections afforded to corporations, LLCs can be a good option.

Note that whether and how your LLC is taxed at the state level varies from state to state. For instance, some states collect a franchise tax on LLCs, either a flat rate or calculated as a percentage of revenue. Please consult a professional to learn how LLCs are taxed in your state.

To obtain S corp status, here are some forms that might apply to your situation (always note filing deadlines): IRS Form 1040 with Schedule C; IRS Form 1065 with Schedule K-1 (for each partner in a partnership). For IRS guidelines on LLC taxation, see IRS Publication 3402.

S Corporation

Pros

  • Personal assets are protected from business debts and lawsuits.

  • No federal corporate tax(but check California state rules).

  • No double taxation.

  • Paid and taxed as a salaried employee, avoid self-employment taxes.

  • Pays dividends and distributions.

  • Qualified Business Income deduction (if eligible).

  • Easy to transfer ownership.

Cons

  • More red tape with start up and running your ESD business.

  • Accounting is more complicated (and therefore more expensive).

  • Limited to 100 shareholders.

  • Must be a U.S. citizen or permanent resident.

  • Shareholders cannot be business entities.

  • Allowed no more than one class of stock.

  • Harder to attract investors than with C corp.

S corporations (S corps) are a type of corporation. If you choose to incorporate, you will first create a C corporation (C corp) and then apply to the IRS for S corp status. S corps were created for smaller businesses that want to operate as corporations for the personal liability protections but without some of the tax burdens, much like LLCs. But there are some differences.

There are two primary benefits to operating your ESD business as an S corp—your personal assets will be protected from business liabilities (as with a C corp), but you won’t be subject to the same “double taxation” as a C corp. As long as you keep your personal finances separate from business finances, your personal assets will remain protected. Your S corp business will be taxed like a sole proprietorship where company profits pass through to your personal tax returns and you are taxed at a personal rather than corporate income tax rate. In fact, your business will not be liable for corporate income tax at all and will avoid “double taxation.” All this is very similar to an LLC, but as the owner of an S corp, you can be paid as a salaried employee (as long as your salary is “reasonable” in the eyes of the IRS), thereby avoiding the more expensive self-employment tax and instead paying the less expensive FICA. Another benefit is that you can be paid dividends or distributions if your company is generating those.

Another benefit of running your business as an S corp is that you may be eligible to take a Qualified Business Income deduction of 20% from your share of business income (your income as an employee), in addition to the usual business expense deductions. There are income limits and other restrictions, so not everyone will be eligible.

The biggest drawback to operating your ESD business as an S corp is that starting up and running your business can be a bit more cumbersome and expensive than for a sole proprietorship or LLC due to corporate regulations and restrictions. For instance, you (and your shareholders) must be U.S. citizens or permanent residents of the U.S. Plus, your business is limited to 100 shareholders, and your shareholders cannot be business entities. In addition, your business will be restricted to one class of stock, and even though you’ll be incorporated, it may be harder to attract investors than if you operated your business as a C corp. Also important to consider is that accounting is more complicated for S corps, something that can significantly increase your accountant fees.

Bottom line, S corps are good for protecting personal assets and easier on your taxes than sole proprietorships and LLCs, but there are higher costs and more red tape.

Note that whether and how your S corp is taxed at the state level varies from state to state. For instance, California treats S corps a bit differently—in California, S corps are not treated as pass-through entities and are taxed directly, though at a lower rate than C corps. There’s more to it than that, so please consult a professional to learn how S corps are taxed in your state.

To obtain S corp status, here are some forms that might apply to your situation (always note filing deadlines): IRS Form 2553, IRS Form 1120-S, Schedule K-1 (Form 1065), and Schedule E (Form 1040), and personal return Form 1040 (for all 1040 forms and schedules, click here).

Terminology

Just a few terms to help better understand the choice between sole proprietorship/partnership, LLC, and S corp.

Company Structures Compared

For purposes of the information below, we will assume that your LLC will not be incorporated. And for ease of language, we will also assume that you are forming a sole proprietorship rather than a partnership (but remember that the rules, benefits, and drawbacks that apply to sole proprietorships also apply to partnerships).

Sole Proprietorship

Protecting Personal Assets

  • Personal assets are not protected from business creditors and lawsuits.

Tax Implications

  • Company revenue passes through to owner’s personal tax returns, so owner taxed at personal, rather than corporate tax rate

  • There is no corporate income tax, so no “double taxation.”

  • Owner pays taxes as self-employed (Schedule C) which means reporting business income and expenses on personal tax returns.

  • Owner pays self-employment rather than FICA taxes because self-employed.

  • Self-employment tax rate calculated as percentage of company profits (up to $142,800 in 2021) rather than as percentage of owner’s salary alone.

  • Note that state taxes may also apply.

Fees & Regulations

  • Fees to set up and run sole proprietorship are lower than for S corps and LLCs.

  • Less paperwork involved in setting up your business.

  • Less regulated than S corps and LLCs (i.e., no requirement to have a board, let alone board-approved bylaws or annual meetings).

  • Accounting more straightforward.

  • Recommend that owner create DBA. File form (i.e., fictitious business name statement) with county or state.

  • Prior to choosing a business name, make sure your preferred name isn’t already taken. Conduct a search of business names on county (i.e., county registrar office) and state (i.e., secretary of state) websites.

LLC

*Assume LLC is run as sole proprietorship or partnership rather than as a corporation.

Protecting Personal Assets

  • LLCs afforded same liability protections as corporation—personal assets are protected from company debts and lawsuits.

  • To maintain this benefit, keep personal finances separate from company finances, no intermingling.

Tax Implications

  • LLCs taxed like sole proprietorships so that taxes pass through to business owner. (The IRS term for this is “disregarded entity,” meaning a business that is separate from its owner but which elects to be disregarded as separate from the business owner for federal tax purposes.)

  • LLC revenue is taxed as personal income. Business owner pays LLC’s taxes on personal tax return using Schedule C.

  • Business is not subject to corporate income tax, so sole proprietorships avoid “double taxation.”

  • Owner’s Social Security and Medicare taxes computed as percentage of company profits up to approximately $142,000 (whereas with S Corp, owner pays these as percentage of owner’s salary).

  • Note that state taxes may also apply.

Fees & Regulations

  • Offer formal business structure, unlike sole proprietorship.

  • Easier than corporations to set up and run, fewer rules and regulations (i.e., although recommended, not required to hold annual meetings or adopt bylaws).

  • Less costly than corporations to set up and run, but more costly than sole proprietorship (i.e., fee to file annual report every year).

  • More difficult for LLCs to attract outside investors than for corporations.

  • Recommended that owner create DBA by filing appropriate form with county or state (i.e., fictitious business name statement).

  • Prior to choosing a business name, make sure your preferred name isn’t already taken. Conduct a search of business names on county (i.e., county registrar office) and state (i.e., secretary of state) websites.

S Corporation

Protecting Personal Assets

  • S corps are afforded same liability protections of C corps—personal assets are protected from company debts and lawsuits. To maintain this benefit, keep personal finances separate from company finances, no intermingling.

Tax Implications

  • S corporations are taxed like sole proprietorships.

  • Company profits pass through to owners’ personal tax returns and owner taxed at personal income tax rate.

  • This avoids “double taxation” that owner would be subject to in a C corporation.

  • Owner paid as employee of company and so avoids self-employment (pays FICA rather than self-employment tax and rate is calculated as percentage of owner’s salary (as long as reasonable in the eyes of IRS) rather than as percentage of company profits (up to $142,800 in 2021).

  • Owner and other shareholders can be paid in dividends or distributions, as well (relevant dividend/distribution taxes will apply).

  • With respect to state taxation of S corps, note that they are treated differently in California than other states (more heavily taxed).

Fees & Regulations

  • Many regulations control S corps (e.g., adopting bylaws, holding annual board meetings, keeping minutes).

  • Owners (all shareholders) must be citizens or permanent residents of US.

  • Limited to 100 shareholders and one class of stock.

  • Cannot be owned by other businesses, including corporations, LLC, partnerships, and sole proprietorships.

  • Not as attractive to investors as C corporations.

  • Fees to establish and manage S corps are higher than for sole proprietorship and some LLCs.

  • Accounting is more complex, so you may incur higher accounting fees.

  • To file for S corp status, use IRS Form 2553. Note tax filing deadlines.

  • Easy to transfer ownership.

  • Prior to choosing a business name, make sure your preferred name isn’t already taken. Conduct a search of business names on county (i.e., county registrar office) and state (i.e., secretary of state) websites.

References

"C and S Corporations," Lumens Learning, https://courses.lumenlearning.com/wm-introductiontobusiness/chapter/c-and-s-corporations/.

“California State Business Income Tax,” David M. Steingold, Nolo (2021) https://www.nolo.com/legal-encyclopedia/california-state-business-income-tax.html.

“Clearing Up Confusion About Disregarded Entities,” Jean Murray, The Balance Small Business (3/30/2020) https://www.thebalancesmb.com/disregarded-entity-definition-and-background-398223.

"Compare Types of Corporations & Business Entities,” Incfile, https://www.incfile.com/business-entity-comparison.

"DBA (Doing Business As): What Is It and How Do I Register?" Priyanka Parakash, Nerd Wallet (5-25-2021) https://www.nerdwallet.com/article/small-business/dba-doing-business-as.

"Do-It-Yourself Checklist to Incorporate Your Business," Drake Forester, Score (10-29-2019) https://www.score.org/resource/do-it-yourself-checklist-incorporate-your-business.

"How Many Shares Should Be Authorized for an Incorporation?" Fraser Sherman, CHRON (7/19/2021) https://smallbusiness.chron.com/many-shares-should-authorized-incorporation-36282.html.

"How Many Shares Should a Startup Authorize?" Capbase (1/26/2021) https://capbase.com/how-many-shares-should-a-startup-authorize/.

“How to Set Up an LLC in 7 Steps,” Rob Watts and Jane Haskins, Forbes Advisor (11/3/2021) https://www.forbes.com/advisor/business/how-to-set-up-an-llc-in-7-steps/.

“How to Start a Corporation,” TRUiC, How to Start an LLC, https://howtostartanllc.com/how-to-start-a-corporation.

"Issuing Shares in an S Corporation: What You Need to Know," UpCounsel, https://www.upcounsel.com/issuing-shares-in-an-s-corporation.

"LLC Vs. S Corp: What Are They And How Are They Different?" Leeron Hoory,  Jane Haskins,  Rob Watts, Forbes Advisor (8/18/2021) https://www.forbes.com/advisor/business/llc-vs-s-corp/.

"LLC vs. S Corporation: What's the Difference?" Christina Majaski, Investopedia (4-10-2021) https://www.investopedia.com/articles/personal-finance/011216/s-corp-vs-llc-which-should-i-choose.asp.

“LLC Taxes by State,” TRUiC, How to Start an LLC (8/27/2021) https://howtostartanllc.com/taxes/llc-taxes/business-taxes.

"S-Corporation Tax Calculator," Incfile, https://www.incfile.com/s-corporation-tax-calculator.

“Should I Elect to Have My LLC Taxed as a Corporation or S Corp?” Jean Murray, The Balance Small Business (7/27/2021) https://www.thebalancesmb.com/should-i-elect-to-have-my-llc-taxed-as-a-corporation-397767.

Tax Return Forms for Personal Filing, 1040 Forms and Schedules, IRS (2020-2021) https://apps.irs.gov/app/picklist/list/formsInstructions.html?value=1040&criteria=formNumber&submitSearch=Find.

"What Is a C Corporation," Incfile, https://www.incfile.com/what-is-c-corporation.

"What is a Limited Liability Company (LLC)?" Nolo https://www.nolo.com/legal-encyclopedia/what-is-a-limited-liability-company.html.

"What Is an S Corporation," Incfile, https://www.incfile.com/what-is-s-corporation.

“What Is an S Corporation?” S Corp Savings Calculator (in article), TRUiC, How to Start an LLC, https://howtostartanllc.com/what-is-an-s-corporation

“What Tax Form Does an LLC File: Everything You Need to Know,” UpCounsel, https://www.upcounsel.com/what-tax-form-does-an-llc-file.

"When forming a company, how many shares should be issued, and at what price?" Rejah Lehal, Clausehound (1-27-2017) https://blog.clausehound.com/when-forming-a-company-how-many-shares-should-be-issued-and-at-what-price/.

"Why You Might Choose S Corp Taxation for Your LLC," Stephen Fishman, Nolo https://www.nolo.com/legal-encyclopedia/why-you-might-choose-s-corp-taxation-your-llc.html

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The information provided in all Association How-Tos and on the Association website does not and is not intended to constitute legal advice, and the information and links are for general informational purposes only. It is possible that some of the information provided in Association How-Tos and on the Association website is not the most up-to-date information or specific to your geographic location (for instance, please note that state laws vary). In addition, Association How-Tos and the Association website contain links to third-party websites—these links are for the convenience of the reader and they do not indicate endorsement of the linked companies, their websites, or the information contained on their websites. Readers of this website should contact an attorney to obtain advice with respect to any particular legal matter, including matters relating to business structure and finance, and should contact an attorney or accountant for information regarding federal and state taxes (note that state taxes vary from state to state). In addition, all the information provided in this article is intended to apply to companies formed in the United States.