Managing a Small Business
Sole Proprietor? LLC? How Businesses Are Set Up
One of an Owner's First Choices Can Have Significant Financial Implications
Business owners make many decisions, but one of the first ones is often picking a structure for the business. Should it be a sole proprietorship? A partnership? A limited liability company or corporation? The decision is not always clear and often varies from state to state.
For many business owners, the selection of a business structure often comes down to individual circumstances. Jenna Guarneri considered two options , an LLC and an S corp, when launching JMG Public Relations, a New York City-based firm specializing in the promotion of clients within the lifestyle and entertainment industries. She made the decision to start out as an LLC.
One of Guarneri's main reasons for opting against an S corp was the requirement of electing a board of directors. "Since I am the sole owner, this did not seem necessary," she says. Guarneri also didn't feel it was necessary to issue stock and corporate distributions characteristic of an S corp.
“What was appealing with the LLC is that it provides limited liability protection to its owners, who are typically not personally responsible for the business debts and liabilities of the LLC," she said.
Christopher Gray, CEO and Founder of Scholly, an app that helps students find scholarships, also said an LLC was an appealing choice, especially because he had partners.
"LLCs make it easier to split equity, know where you and your co-founders stand, usually via an operating agreement, and provide no liability to the founders if something goes wrong. All of which were attractive to college-aged founders starting a business for the first time."
Know Your Guidelines
While laws do vary from state to state, the Small Business Administration notes that there are some general guidelines most LLCs must follow.
- Choose a Business Name: It should be different from an existing LLC. It cannot include words restricted by your state. And it should be registered with your state when you register your business.
- Include Articles of Organization: This document includes your business name, address and member names. In most states, the SBA says on its website, you file with the Secretary of State. Some states also require you to file with other government organizations. Ask an attorney in your state what agencies you will need to file with.
- Create an Operating Agreement: While many states do not require operating agreements, the SBA recommends them for multi-member LLCs because it “structures your LLC's finances and organization, and provides rules and regulations for smooth operation."
As a general rule, the federal government does not consider an LLC a separate tax entity, so the business itself is not taxed. Federal income taxes are the responsibility of the LLC members and are paid through their personal income tax returns. Some states do tax income on an LLC, so you should check with your state's income tax agency.
"The IRS treats the business as a sole proprietorship, and you can include all of the activity from the LLC on your personal tax return without the need to file a separate federal return," says Steven Sanders, CPA and managing member of Sanders & Co. LLC in Dallas.
"If the LLC has multiple members, the business may elect to be considered a partnership or corporation," Sanders says. "Most multiple-owner LLCs choose partnership because they want the pass-through benefits and the flexibility of a partnership," he adds.
For guidelines about how to classify an LLC, visit IRS.gov.
A sole proprietorship is a business owned and operated by one individual. Income from the business is generally reported on your personal tax forms, and the structure can be simple.
The SBA notes that because your business is not taxed separately, it is often easy to fulfill the tax reporting requirements, and rates are the lowest of the business structures.
Tonya Kerry opted to start out as a sole proprietor when she formed her business, Love Smart Be Amazing, in 2014. Kerry has a diverse business that includes professional speaking, working with single professional women in developing relationships and helping female leaders create happiness in the workplace. For now, the sole proprietorship works for her because she has no payroll (she manages her business with volunteers), she says. As she makes plans for a conference in late 2016, however, Kerry is a considering whether to convert to an LLC.
“Because we're planning for conferences and training on a large scale, we want to make sure we are properly protected," she says.
An S Corp is a corporation created through an IRS tax election. According to the SBA, eligible domestic corporations can avoid double taxation (once to the corporation and again to the shareholders) by structuring a business as an S Corp.
According to the SBA, what makes an S Corp different from a traditional corporation is that profits and losses can pass through to your personal tax return, and only shareholders are taxed, not the business itself. Additionally, shareholders do not pay employment taxes on S corp distributions.
"Many people are attracted to S corps because of this advantage," Sanders says.
When Lacy Eidens started a children's clothing boutique with a partner, they were unsure of how to structure the business.
“When my partner and I started out we were an LLC, and our accountant told us we should become an S Corp. He said we were missing out on tax savings by not being an S Corp. Also, he said if one of the partners decides to leave the company or sell shares, the S corp isn't really affected."
Another option available to some businesses is to create an LLC that is treated for tax purposes as an S corp.
In determining which business structure is right for you, turn to professionals to understand the legal and tax aspects of your choice. "Be mindful that there are benefits and detriments to each type of business structure," Sanders says. "A tax advisor can help you determine what best suits your goals, objectives and risk tolerances."
And an experienced business attorney can help you get started on the right path, says Frank Goldman, a business attorney who has been practicing in Georgia for 20 years.
"Establishing a relationship with an attorney at the very outset — someone who can be with you through the maturation of your business — is extremely valuable."
The information expressed is being provided for informational and educational purposes only. It does not intend to provide specific advice or recommendations for any individual and should not be relied on for accounting, legal, financial or tax advice. You should carefully consider your needs and objectives before making any decisions. For specific guidance on how this information can be applied to your situation, you should consult your financial, accounting, legal or other advisors.
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Illustration by Kotryna Zukauskaite