Business Entities: Which One is Right for Me?
By: Hugh Pendleton, President
So, you’re about to start a business or have a side hustle that’s ready to go full-time, but when researching business types, you come across a variety of options: LLC, Corporation, General Partnership, DBA. What are they and what do they mean?
All of these are separate business entities. Your business entity defines the legal structure of your business. For example, are you the owner and sole employee? Do you have partners? Do multiple brands fall under one larger business?
Each business entity has different legal, tax, and profit sharing requirements, so understanding the differences before filing any paperwork is both helpful and necessary. Here is an overview of the four primary types of business to help you decide which may be the best fit for your business.* And remember, while you may fit under one business entity now, this can change over time as you grow.
The simplest form of business is a sole proprietorship, often registered as a DBA (Doing Business As). A DBA is useful if you’re just starting out and have no partners. DBAs are low cost and only require a registration fee and a renewal fee about every five years. You can use your name for this type of entity, or you can make up a name for your business. We recommend creating a name you like that fits your services and can grow with your business.
Costs and Paperwork
A DBA is easy to set up. You merely file a DBA with the county recorder and publish a DBA statement. The total cost to set up is usually under $150, and the annual costs are the additional tax preparation fees that you will pay to report your business activities.
Because you’re doing business as yourself, DBAs don’t offer liability protection, and you should carry business insurance to protect yourself. Business insurance is between $100-200 per month and mainly covers personal and property liability, but not product or professional liability. Those are specialized insurance and you should talk to a broker to determine if you have any special liability insurance needs.
With a DBA, you report and pay taxes at the individual level, including self-employment tax. You can do this by filing a Schedule C as part of your individual tax return. A Schedule C reports all of your sales and expenses resulting in a final a net income on which you pay both self-employment (Social Security) and income taxes. Plan to set aside between 30-45% of your monthly income to cover your taxes (depending on your state).
For your income, there aren’t any specific rules regarding owner’s pay. All of the money left over after you pay your taxes is yours to use any way you want.
The next form of business is a general partnership. A general partnership is the simplest multi-owner form of business. It's also one of the most flexible forms of business ownership. Profits and responsibilities can be organized in any way the partners decide as long as it represents economic reality; i.e., the distributed profits need to match the given responsibilities, and capital contributed.
Costs and Paperwork
You will need to file a DBA listing the partners. You may also wish to record the partnership agreement with the county. The combined costs for this are under $300. Annually you will need to file partnership returns with both the state and the IRS. The cost for this varies by preparer. We recommend using a CPA or EA who prepares these returns on a regular basis.
You will need a written agreement between the partners outlining your duties, capital (money contributed) and profit sharing. As with the sole proprietor, there is no legal liability protection, and partnerships need to be adequately insured.
A General Partnership doesn’t pay tax. Instead, every partner is responsible for paying taxes individually on their earnings. The partnership does need to file a separate tax return which covers the earnings of each partner. The partners receive earnings statements called K-1s that show how much they’ve earned and how much they need to pay in tax. As an individual partner, plan to set aside between 30% and 45% of your total profits to cover your taxes.
Partnerships are very flexible as there is almost no limit to how the partners can organize their affairs as far as capital and profit sharing. The most common divisions are based on levels of responsibility and investment; i.e., those who invest most and carry more responsibility receive a more significant share of the profits.
Unlike a DBA or partnership, a Limited Liability Company (LLC) is a distinct business entity separate from its owner(s). One of the most significant benefits of forming an LLC is that it provides substantial legal liability protection. Apart from the liability protection, LLCs can operate in the same manner as a general partnership, although they aren’t quite as flexible. They can also elect to operate as a corporation, which means a formal structure where they can only distribute profits as salaries and dividends.
Costs and Paperwork
An LLC must be organized in the state in which it does business. It must have a formal charter and governing documents and must renew its registration periodically (frequency depends on the state). To be correctly set up you should use a business attorney and the costs for the setup are often $2,000 or more to do this correctly.
LLCs are considered “persons” that can conduct business, enter into contracts, sue other people or businesses, and be sued themselves. An LLC provides liability protection for your assets not included in the LLC, like your home, 401K, investments, etc. While your business and its assets are fair game in the event of bankruptcy or a lawsuit, the LLC protects any assets unassociated with the business.
It also provides a high level of protection against losses of any type that exceed the money contributed by each partner and their share of any loan guarantees. This legal protection is especially important if your business is subject to unknown or uninsurable risks like lawsuits, government regulations, or even political risks.
From a tax point of view, an LLC is the most confusing and frustrating legal entity known to man. A single owner LLC can be ignored for tax purposes and reported as a Schedule C on your individual tax return. A multi-member LLC is taxed as a Partnership but may choose to be taxed as a Corporation, or an S Corporation. Any tax election is long-term and can’t be changed at whim, so careful consideration should be made when making a tax classification election. This is a complex area; please consult a professional tax advisor before making this choice.
Profit distributions are based upon the type of taxation elected. You can read more about this under each of the other entities.
Unlike other business entities, a Corporation is not a partnership. It’s a more standardized form of organization where the owners are called shareholders or stockholders because shares of stock evidence their ownership. This is a flexible ownership arrangement as the shares can be transferred without the approval of any other shareholders. New stock can also be issued to raise additional capital with the approval of a majority of shareholders (owners).
Costs and Paperwork
Like an LLC, a Corporation must be organized in the state in which it’s doing business. It must have a formal charter and governing documents and must renew its registration periodically (frequency depends on the state). To be correctly set up you should use a business attorney and the costs for the setup are often $2,000 or more to do this correctly.
Like LLCs, Corporations are considered “persons” that can conduct business, enter into contracts, sue other people or businesses, and be sued themselves. Because a Corporation is also a separate legal entity, it also provides similar legal protections to the LLC.
A Corporation typically pays tax on its own. Any profits left over after paying salaries to the owners are subject to tax at the Corporate level. This tax can range from 15% to 35% at the Federal level plus state tax. After the corporation pays this tax, it adds the remainder to retained earnings, and dividends can be paid to stockholders out of this per their ownership shares. These dividends are taxable to the stockholders. Consequently, many Corporations choose not to pay dividends but instead use the retained earnings to help grow the business. Since the corporate tax rate can be lower than the individual tax rate, corporations can be a useful vehicle for accumulating working capital for the business.
Alternatively, a corporation can elect to have the taxable income flow to the shareholders by making an S election with the IRS. This is useful for a company which does not need to accumulate additional capital and where the shareholders would like to avoid the double taxation on their dividends. Again, this is a long-term election, and you can't change it at whim, so careful consideration should be made when making a tax classification election.
A Corporation can only distribute profits in the form of salaries or dividends to its shareholders. Any Corporation which makes the S Election may distribute all or part of its pre-tax profits to the shareholders based on their shares of stock. Nevertheless, all profits are taxable to the shareholders.
Deciding to move forward with your business idea is tough, and the formal legal considerations and requirements don’t make it any easier. But hopefully, you now have a better grasp on how the different business entities affect liability, taxation, overall structure and profit sharing. Even seemingly identical businesses will have different needs and requirements, so consult with both your attorney and tax advisor before making a decision.
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*This article is for general information purposes only and does not provide any tax or legal advice. Before choosing a business form, please consult your accountant and attorney for professional tax and legal advice.