There are four primary types of business models and many subtypes. Your accountant can help you determine which one is best for you; even if you use this book and do your own research, you should run the ramifications of your choice by a tax accountant or legal advisor (I recommend both), because individual circumstances, like personal write-offs and other legal implications, can drastically change the outcome of your selection from a tax perspective.
Additionally, each method of structuring your business offers various types of protection for you and/or your family, should your business be sued or be negligent in some way.
What did our survey participants choose for their business structure? Nearly half, at 48 percent, chose a sole proprietorship. Next, at over one quarter (26 percent) was a limited liability corporation. 10 percent have an S corporation, 6 percent have a partnership, 4 percent have a C corporation, and 6 percent noted “other.” Those others noted that their business was unstructured or that they weren’t sure they needed a structure and didn’t know there was such a thing.
1. Sole Proprietorship
The first and perhaps easiest of the four structures is a sole proprietorship. A sole proprietorship is the method many of us use to begin with, until we get big enough to form some kind of formal corporation, or unless our liability from the start is substantial. There are many examples of substantial liability, but some are: businesses teaching people how to fly small planes and get their pilot’s license; day care facilities, restaurants, and so on. Anything involving more risk than you care to assume on your own should possibly be put into a corporate format. Also, if your company manages property or owns a building or premises in which someone could be hurt and sue for damages, consider other options than a sole proprietorship. Another case in which you would want to consider a structure other than sole proprietorship is any time that an individual must drive for you and they are your employee, like a pizza driver.
A sole proprietorship is easily established. You will need a name and a business checking account, and you will report income on a Schedule C with your Form 1040 for your personal taxes.
First things first! Find the name that best suits your business. Go to your local government, which will usually be your county—most counties have the information on their website about “how to start a small business.” They will usually require a small business license, which can range from $10 to $500 per county. After this, you need to establish that the business is, in essence, you. Entrepreneurs do this through a DBA, or “doing business as” request. To do this, you file a DBA form through your county, which will usually require that you publish the name in some media form (usually small town newspapers qualify, and the government will most often give you a list of papers and prices) for a certain number of weeks, which again varies by county or city. In my experience, it could be as little as one week or as long as two months. (Be prepared—many companies scour these parts of newspapers to start sending bulk junk mail, usually arriving within three to five days of when you first publish!)
After the DBA is established, you bring the business name certificate and business license, along with identification, to a bank. Show them your documents, and establish a business checking account. Essentially this method will work for all types of corporations, too. Remember, it is essential to keep personal and business funds separate, regardless of what business model you choose. If you need cash to cover business expenses, you need to write yourself a check and document it as owner’s equity (or document it based on the advice of your financial planner or accountant). Most accountants are well versed in the common bookkeeping software most of us use, so if you run into any concerns, most will assist you with how to make the entries into your own system.
After you have your business checking account and business license, you’re free to do business—just be sure to keep your business and personal expenses separate. I like to use NeatReceipts Professional to scan all of my business receipts and automatically categorize them into IRS buckets—the lines the IRS uses in Schedule C. Using this method saves both time and money come tax time, as not only am I having to take up less time during my annual session with my accountant, but I am also saving personal time when preparing for that appointment, which in turn allows me more time to work and lets me focus less on administrative stuff.
If you are in a riskier business or want to start off as a separate corporation, look into other options, which are discussed later in this section of the book on corporations.
A partnership is essentially set up the same as a sole proprietorship with one exception—you have a partner. Each of you owns a named percentage of the business, which is also reported on a Schedule C with your Form 1040. This is very similar to a sole proprietorship, in that it offers little to no protection from risk, but it is very simple and straightforward to set up.
When you fill out the business registration forms with your county, one of the check boxes will be for a partnership. Generally the same rules and procedures are followed regardless of the county, city, or state, and both names go on the business checking as “DBA.” Keep in mind that you cannot take a person off a checking account once it is opened, so if your business partner leaves, you have to reopen your checking and refile both the business license (some counties and cities will let you do a business modification) and a new DBA form, since your partner is no longer doing business under that name.
There are obvious risks here, like your partner leaving or having a medical crisis, and not having full control over your business. Everyone has her own rules, but (after hearing too many horror stories) I personally believe—no partnerships. Save them for marriage, and perhaps private lending. There cannot be two kings (or two queens)—someone needs to have the final decision. That is only my opinion, however, and many former business school peers or friends have successfully started partnerships with no issues.
In this scenario, since risk is passed off to both parties, you are assuming the same percentage of risk as you own in the business. If you have a 60/40 split, the partner with 60 percent assumes 60 percent of the risk, unless otherwise documented.
Also remember that your accountants will need to work together, or if you are preparing taxes yourself, be sure to read the IRS’s rules about how to file for partnerships.
Note that partnerships are not limited to two persons. In most cases, you are allowed one or more additional parties, which will lessen the risk potential of each involved party, pending a fair split of responsibility and ownership.
There are two primary types of the basic corporation—S corp and C corp—each with its own pros and cons.
A corporation in general has one big advantage, and that is limited liability due to you and your business being two separate entities. In essence, your business is now its own living and tax-paying being. Upon structuring as a corporation you will receive a tax identification number or Employer Identification Number (known as an EIN), which is similar to your own Social Security number. The corporation will be required to pay taxes to the IRS just as you are. Another advantage, speaking of taxes, is the corporate tax liability (which is often less than personal tax liability) and a true separation between business and personal taxes (although this can be a grey area with an S corp, as it is considered a passthrough structure).
Generally, corporations file quarterly taxes, making life a bit more difficult for the entrepreneur, especially if you’re just starting and don’t have much to report. You will usually make estimated tax payments as a corporation. For more information, see IRS Publication 505, consult with your tax professional, or both.
Structuring your business as a corporation as a way to separate taxes is a tricky situation, however, as the IRS considers an S corp to be a “pass-through” entity, meaning that all of the tax liability will pass through to your personal bottom line. I cannot stress enough that you should consult with a tax professional, accountant, and legal counsel prior to making the decision to structure your company. At the very least, consult your state tax laws, the federal IRS tax laws, research thoroughly, and consult with your local SBA office.
Double taxation, according to Investopedia, is “A taxation principle referring to income taxes that are paid twice on the same source of earned income.” Investopedia continues with the following explanation:
“Double taxation occurs because corporations are considered separate legal entities from their shareholders. As such, corporations pay taxes on their annual earnings, just as individuals do. When corporations pay out dividends to shareholders, those dividend payments incur income tax liabilities for the shareholders who receive them, even though the earnings that provided the cash to pay the dividends had already been taxed at the corporate level.” (Investopedia, 2008)
Note that you probably won’t have shareholders beyond yourself and/or your business partners in the beginning. Also remember, though, that you don’t have to be a public company to offer shares of stock. Plenty of private companies have stock available for sale.
Remember that you can always become a corporation later on down the road and start off the easier way by becoming a sole proprietor (it is far less paperwork and less difficult to file taxes), unless you will have a significant level of risk immediately upon starting your business, or you are looking to turn a substantial profit and you will have substantial startup costs.
4. Limited Liability Corporation
A limited liability corporation, commonly referred to as an “LLC,” is one way to limit your liability without creating a big headache come tax time. I have an LLC that is easily managed and is easy to file taxes for.
A limited liability corporation is set up to do precisely what it implies: limit the owner’s liability. It is reported like a regular sole proprietorship on a Schedule C with your 1040, and can provide the same benefits—like a home office write-off— that sole proprietors enjoy, yet will limit your liability because it protects you as an individual from your business. Two exceptions to this are farms and real estate rental properties, which require a Schedule F and E, respectively.
As an example of an LLC used to own and manage a real estate business, I use my own LLC to deed my rental properties into the business, rather than having them owned by me personally. Since real estate transactions are a bit different and my LLC has relatively little credit or positive net assets (and most banks won’t lend to LLCs to buy properties anyway), I buy the properties myself, then using a quit claim deed form, I “give them” to my LLC. My LLC files its own Schedule E, for real estate businesses and income-generating properties, and has its own Employer Identification Number. My LLC is free to hire employees as any corporation is, but if an individual is hurt in my property beyond what my insurance covers, my primary home cannot be touched nor can my personal property.
Are you protected individually with an LLC? Yes. But remember, all assets that your LLC owns are at risk. If you own assets that have to have insurance, be sure you add your LLC as a named insured. In the case of real estate investment properties, the mortgagee, the second lien holder, myself as an individual, and my LLC all must be specifically named insured on the policies. If you have an umbrella policy, talk with your insurance broker or representative about adding your LLC to the policy, too.
Overall, the pros and cons of an LLC are as follows:
One advantage to the LLC structure is that it allows for an unlimited number of members. If the LLC has just one owner, however, it will be taxed as a sole proprietorship. Also, the LLC model provides for limited liability for all members, which means that they are personally protected from any liability of the LLC and successful lawsuits, as well as from the LLC itself.
Some of the disadvantages include the fact that, as a member of an LLC, you are not allowed to pay yourself a salary, and the managing member’s share of the bottom line profit of the LLC is considered earned income, meaning it is subject to self-employment taxation, which can be higher than corporate taxes.
Source: Babb Danielle (2009), The Accidental Startup: How to Realize Your True Potential by Becoming Your Own Boss. Alpha.
One thought on “Types of Startup Businesses”
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