Can Choosing the Wrong Business Type Ruin Your Business Plans?

So, you’re starting a business, and you’re probably overwhelmed by the choices from LLC, sole proprietorship, corporation, or partnership.

I’m here as a CPA to explain to you, and break down the pros and cons of each of these business types, and who they’re best for.

I’ll also share my #1 personal recommendation, and I’ll warn you, my answer is a little controversial…    

So the big question is...

Why should you even care about picking the right business type for your business?

Think of it like this: Choosing your business structure is like… deciding on the perfect pair of shoes. A flashy pair of wing tip dress shoes might look great with a suit, but they're not going to be much help on a hiking trail. Just like those shoes, your business type dictates a whole lot on—how much you pay in taxes, who's responsible if there's a problem, and even what’s best if you want to grow and expand. 

Let’s go over the typical options...

There are four main ones: Sole Proprietorship, Partnership, Corporation (which includes C Corps and S Corps), and LLCs. Think of these as pieces in a chess game, each with it’s own special abilities and of course some weaknesses.

Sole Proprietorship -

A sole proprietorship is a type of business where there's just one owner, and there's no difference between the owner and the business. 

Pros of Sole Proprietorship:

• No formal creation process.
• Easy to operate and dissolve.
• No separate tax return. 
• Easy to integrate business use of home deductions
• No double taxation of profits.

Cons of Sole Proprietorship:

• No liability protection, except through insurance. 
• Self-employment tax is assessed on entire net profit of the business. 
• Transfer of ownership can be complex. If you stop, the business stops.
• Limited Resources: Often just you, so less time and money for growth.

Who are these best for? 

• Casual business.
• Favors simplicity. 
  
  

Partnership

A partnership is a type of business where two or more people own and run the company together. They share the money the business makes and also the risks and debts. Each partner is involved in the decisions and day-to-day stuff unless they agree to divide the work differently.

 Pros of Partnership:

• Simple creation process.
• No limit on parter number or type.
• Flexible allocation of profit, loss, and distributions.
• Favorable tax treatment when liquidated.
• No double taxation of profits.

Cons of Partnership:

• Requires a separate tax return.
• Unlimited liability for all partners.
• Difficult to dissolve or change ownership without substantial planning.
• Requires tracking of basis for partners, both inside and outside the partnership.
• Individual partner’s share of income is subject to self-employment taxes.

Who are these best for? 

• Businesses with partners not actively involved in the business.
• People who want to team up with a friend, family, or business partner.
• Small to medium-sized businesses.
• Individuals who trust their partners, as each is personally responsible for debts and actions.

Disclaimer. I’m not a lawyer, and none of this should be considered as legal advice. With the creation of any legal entity, you should consult with an attorney or online legal service, especially for the creation part of it. It’s fine for accountants, and tax professionals to offer guidance on this, but in my opinion, since it’s a legal entity being created, it should be handled by a lawyer. 

C Corporation -

A C Corporation is a type of business that's separate from its owners, called shareholders. It can make its own money, pay its own taxes, and even get sued. Shareholders own pieces of the company through stocks. They elect a board of directors to make big decisions.

Pros of C Corporation:

• No liability for non-active stockholders.
• No restrictions on ownership.
• Ownership can be transferred through the sale of stock.
• Separate entity from stockholders.
• Fringe benefits for owner-officers.
• Can have ownership interest in any other business. entity.
• Perpetual existence.
• Raising capital can be achieved by issuing stock.

Cons of C Corporation:

• Double taxation of profits.
• Complex and expensive to create and maintain.
• Requires regular board of directors’ meetings and minutes
• Requires a separate tax return.

Who are these best for? 

• Businesses planning to go big or go public.
• Companies that want to attract investors.
• Business owners who want to protect their personal assets from business debts or lawsuits.
• Companies that want flexible profit-sharing among owners.
• Businesses that plan to offer employee benefits like stock options.
• Those who are okay with more regulations and paperwork.
• Businesses that don't mind double taxation: the corporation pays taxes and shareholders pay taxes on dividends.

S Corporation -

An S Corporation is like a blend of a C Corporation and a partnership. It lets a business have the protective shell of a corporation but be taxed like a partnership. That means no double taxation! The profits and losses go straight to the owners' personal taxes. 

Pros of S Corporation:

• Liability protection similar to that of C corporations.
• No double taxation of profits.
• Ownership is easily transferred through the sale of stock.
• Separate entity from stockholders.
• Self-employment tax is not assessed on the entire net profit of the business.
• Losses can offset shareholders’ other taxable income.

Cons of S Corporation:

• Complex and expensive to create and maintain.
• Requires a separate tax return.
• Requires regular board of directors’ meetings and minutes.
• Requires tracking of basis for stockholders.
• Ownership is limited to specific types of entities
• Deductibility of fringe benefits for owner-employees is limited.
• Salary Requirement for Owners: Those who own and work in the company must pay themselves a "reasonable" salary, which is subject to payroll taxes.

Who are these best for? 

• Small businesses that want corporate benefits without double taxation.
• Owners who want to protect their personal assets from business debts.
• Companies with a limited number of shareholders.
• Businesses looking for a simpler tax structure, where profits and losses flow through to personal taxes.
• Companies comfortable with meeting specific rules to maintain S Corp status.

LLC or Limited Liability Company -

An LLC, is a business structure that gives you the personal asset protection of a corporation and the opportunity to be taxed as a partnership or corporation. The owners are called members, and as far as the IRS is concerned, it’s a disregarded entity. Meaning, it’s taxed by default; as a sole proprietorship if there’s only one member, taxed as a partnership if there are multiple members, or taxed as a C or S corporation if you fill out the appropriate paperwork.

Pros of LLC:

• Simple creation process.
• Flexible Taxation. 
• Liability protection for members.
• Easy to operate, less paperwork.
• Ownership Flexibility. 

Cons of LLC:

• Confusing taxes. 
• Laws regulating LLCs vary widely among states.
• Other. 

Who are these best for? 

LLCs are great for the flexibility, and the ease to set up. You also don’t have the formalities like you would have for corporations, like board meetings and minutes.

My personal favorite business entity is the single member LLC. This gives you limited liability protection, without the the need to file a separate tax return. Filing a separate tax return can be expensive, not to mention the burden and cost of having a proper accounting system to keep track of all the financial transactions.

Choosing the right business structure can set you on a path to success or challenges. So, pick wisely and consider getting advice from professionals, like an accountant or a lawyer.

Thanks for reading and see you in the blog post!