Whether you’re just starting out or you’ve been in the small business game awhile, right now, you’re likely filled with questions. Like, “Is this the right time to turn my passion into a business?” Or, “How am I going to survive if the economy doesn’t bounce back?” Without a doubt, both are important questions, regardless of the pandemic.
Another question small business owners might have is, “What’s the best business entity structure for my small business?” Your business structure influences everything from your day-to-day operations to your taxes and personal liability. Different structures can affect legal protection and tax responsibility. Most small businesses start as a sole proprietorship or limited liability company (LLC).
The simplest business structure is the sole proprietorship, which you own completely, with no distinction between yourself and the business. That also makes you responsible for all the debts and liabilities of your company. So, if you’re sued or your business goes under, your personal assets are fair game for creditors and you assume all legal liability. While that may sound scary, you should weigh the advantages and disadvantages of a sole proprietorship and decide what’s right for you.
Advantages: Sole proprietors have complete control over their business and all decisions made on its behalf. Also, the costs of forming a sole proprietorship are minimal. If you eventually want to sell your business, you can do so without having to consult with other business partners. Plus, there are no corporate tax payments.
Disadvantages: Remember, you can be held personally liable for the debts and legal obligations of your business. And being responsible for all business decisions can be a daunting proposition. The buck stops with you. Also, if you’re hoping to eventually expand, investors don’t typically invest in sole proprietorships without taking an ownership interest.
Limited Liability Company (LLC)
Many small businesses are structured as LLCs because they offer some of the advantages of a sole proprietorship without its obvious disadvantages. The real benefit is that LLCs are not taxed as a separate entity (as long as the LLC has not elected to be taxed as a C corporation) — all profits and losses are attributed to each owner-member of the company, and you’ll report all business income on your personal tax return. Also, as a single member LLC, you’re in charge — you own, manage and run your business, but without the same liability issues of a sole proprietor.
To get set up, you’ll register your LLC’s existence by filing articles of organization and paying a fee to your relevant state office, normally the secretary of state. While this involves more paperwork and hassle than establishing a sole proprietorship, it’s still relatively easy and can usually be done online. The key advantages of an LLC include:
Limited personal liability: An LLC is viewed as a legal entity separate from its individual members or owners. Generally, that means you won’t be held personally liable for your LLC’s debts or legal liabilities, and your personal assets — like your home or personal bank account — aren’t at risk. However, be careful. Under certain circumstances, such as if you personally guarantee a business debt, you’re still on the hook for it personally.
Pass-through tax treatment: LLCs receive what’s called ‘pass through’ treatment, allowing allocated profits to be taxed only once on each member’s individual income tax return. LLCs that also qualify as partnerships or S corporations may also receive ‘pass through’ treatment from the IRS. Note, this is not the case if you decide to have the LLC taxed as a C corporation for federal income tax purposes.
The disadvantages of LLCs include the additional administrative requirements when compared to a sole proprietorship, and the costs involved. Also, as an LLC owner, you may have to pay unemployment compensation for yourself (if you elect to have the LLC taxed as a C or S corporation), which you wouldn’t have to pay as a sole proprietor.
This is just a primer on business entity structures — there are many more options to consider for your small business. It’s not a one-size-fits-all decision. If you’re confused, you don’t have to go it alone. H&R Block’s Block Advisors can help.
“As part of our personalized tax service, Block Advisors will conduct a business entity structure analysis to see how different structures could impact your taxes,” said Ian Hardman, General Manager and Vice President of Small Business at H&R Block.
Block Advisors, a team within H&R Block, is dedicated to meeting the tax, bookkeeping and payroll needs of small business owners year-round. To start working with the experts at Block Advisors, visit blockadvisors.com.
Disclaimer: Taxes are only some of many factors to consider when selecting an entity. We recommend that you seek the advice of an attorney about other implications of entity selection.