Choose a Business Structure
Learn more about different types of business structures and their legal and tax implications to find which one is right for you.
Virginia Beach Economic Development
Business Structure Types
A sole proprietorship is a simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and the owner. You are entitled to all profits and are responsible for all your business’s debts, losses, and liabilities.
Advantages of Sole Proprietorship
- Easy and inexpensive to form. A sole proprietorship is the simplest and least expensive business structure to establish.
- Complete control. Because you are the sole owner of the business, you have complete control over all decisions.
- Simplified tax preparation. Your business is not taxed separately, so it’s easy to fulfill the tax reporting requirements.
Disadvantages of a Sole Proprietorship
- Unlimited personal liability. Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred because of employee actions.
- Hard to raise money. Sole proprietors often face challenges when trying to raise money. Because you can’t sell stock in the business, investors won't often invest. Banks are also hesitant to lend to a sole proprietorship because of a perceived lack of credibility when it comes to repayment if the business fails.
- Heavy burden. The flipside of complete control is the burden and pressure it can impose. You alone are responsible for the successes and failures of your business.
For more information on sole proprietorships, visit the Small Business Administration website.
A limited liability company (LLC) is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.
The "owners" of an LLC are referred to as "members." Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations, or other LLCs.
Unlike shareholders in a corporation, LLCs are not taxed as separate business entities. Instead, all profits and losses are "passed through" the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.
Advantages of an LLC
- Limited liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members' personal assets are usually exempt. This is like the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means just that - members are not necessarily shielded from wrongful acts, including those of their employees.
- Less recordkeeping. An LLC's operational ease is one of its greatest advantages. Compared to an S-Corporation, there is less registration paperwork and their start-up costs are lower.
- Profit-sharing. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity. Consequently, it's up to the members themselves to decide who has earned what percentage of the profits or losses.
Disadvantages of an LLC
- Limited life. In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways. However, you can include provisions in your operating agreement to prolong the life of the LLC if a member decides to leave the business.
- Self-employment taxes. Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.
For more information on LLCs, please visit the Small Business Administration website.
A cooperative is a business or organization owned by and operated for the benefit of those using its services. Profits and earnings generated by the cooperative are distributed among the members, also known as user-owners.
Typically, an elected board of directors and officers run the cooperative while regular members have voting power to control its direction. Members can become part of the cooperative by purchasing shares, though the amount of shares they hold does not affect the weight of their vote.
Cooperatives are common in the healthcare, retail, agriculture, art, and restaurant industries.
Advantages of a Cooperative
- Less taxation. Like an LLC, cooperatives that are incorporated normally are not taxed on surplus earnings (or patronage dividends) refunded to members. Therefore, members of a cooperative are only taxed once on their income from the cooperative and not on both the individual and the cooperative level.
- Funding opportunities. Depending on the type of cooperative you own or participate in, there are a variety of government-sponsored grant programs to help you start. For example, the USDA Rural Development program offers grants to those establishing and operating new and existing rural development cooperatives.
- Reduce costs and improve products and services. By leveraging their size, cooperatives can more easily obtain discounts on supplies and other materials and services. Suppliers are more likely to give better products and services because they are working with a customer of a more substantial size. Consequently, the members of the cooperative can focus on improving products and services.
- Perpetual existence. A cooperative structure brings less disruption and more continuity to the business. Unlike other business structures, members in a cooperative can routinely join or leave the business without causing dissolution.
- Democratic organization. Democracy is a defining element of cooperatives. The democratic structure of a cooperative ensures that it serves its members' needs. The amount of a member's monetary investment in the cooperative does not affect the weight of each vote, so no member-owner can dominate the decision-making process. The "one member-one vote" philosophy particularly appeals to smaller investors because they have as much say in the organization as a larger investor does.
Disadvantages of a Cooperative
- Obtaining capital through investors. Cooperatives may suffer from slower cash flow since a member's incentive to contribute depends on how much they use the cooperative's services and products. While the "one member - one vote" philosophy is appealing to small investors, larger investors may choose to invest their money elsewhere because a larger share investment in the cooperative does not translate to greater decision-making power.
- Lack of membership and participation. If members do not fully participate and perform their duties, whether it be voting or carrying out daily operations, then the business cannot operate at full capacity. If a lack of participation becomes an ongoing issue for a cooperative, it could risk losing members.
For more information on cooperatives, visit the Small Business Administration website.
A corporation (sometimes referred to as a C corporation) is an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.
Corporations are more complex than other business structures because they tend to have costly administrative fees and complex tax and legal requirements. Because of these issues, corporations are suggested for established, larger companies with multiple employees.
For businesses in that position, corporations offer the ability to sell ownership shares in the business through stock offerings. “Going public” through an initial public offering (IPO) is a major selling point in attracting investment capital and high-quality employees.
Advantages of a Corporation
- Limited liability. When it comes to taking responsibility for business debts and actions of a corporation, shareholders’ personal assets are protected. Shareholders can generally only be held accountable for their investment in the stock of the company.
- Ability to generate capital. Corporations have an advantage when it comes to raising capital for their business - the ability to raise funds through the sale of stock.
- Corporate tax treatment. Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits are awarded a corporate tax rate, which is usually lower than a personal income tax rate.
- Attractive to potential employees. Corporations are generally able to attract and hire high-quality and motivated employees because they offer competitive benefits and the potential for partial ownership through stock options.
Disadvantages of a Corporation
- Time and money. Corporations are costly and time-consuming ventures to start and operate. Incorporating requires start-up, operating, and tax costs that most other structures do not require.
- Double taxing. In some cases, corporations are taxed twice - first, when the company makes a profit, and again when dividends are paid to shareholders.
- Additional paperwork. Because corporations are highly regulated by federal, state, and in some cases local agencies, there are increased paperwork and recordkeeping burdens associated with this entity.
For more information on corporations, visit the Small Business Administration website.
An S corporation (also referred to as an S Corp) is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation.
An S corp is a corporation with the subchapter S designation from the IRS. What makes the S corp different from a traditional corporation (C corp) is that profits and losses can pass through to your personal tax return. Consequently, the business is not taxed itself. Only the shareholders are taxed. There is an important caveat, however: any shareholder who works for the company must pay him or herself "reasonable compensation." The shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as "wages."
Forming an S Corporation
To file as an S corporation, you must first file as a corporation. After you are considered a corporation, all shareholders must sign and file Form 2553 to elect your corporation to become an S corporation.
Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state, and locality.
Advantages of an S Corporation
- Tax savings. One of the best features of the S Corp is the tax savings for you and your business. While members of a limited liability corporation (LLC) are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a "distribution," which is taxed at a lower rate, if at all.
- Business expense tax credits. Some expenses that shareholders/employees incur can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, then benefits like health and life insurance are deemed taxable income.
- Independent life. An S corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.
Disadvantages of an S Corporation
- Stricter operational processes. As a separate structure, S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption, and updates to by-laws, stock transfers, and records maintenance.
- Shareholder compensation requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results.
For more information on S corporations, visit the Small Business Administration website.
CPA on Call Sessions
Do you have questions about your business taxes? Do you need help understanding your financial statements? Get your questions answered during a 30-minute one-on-one session with a CPA from Pixel Financial Group.
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