Many people aspire to own their own business. According to recent research, the young adults of the present day are attracted to entrepreneurship for two key reasons: to create some work for themselves where an inert economy is unable to, and for the freedom that this career grants a person. These aspirations were only enhanced by COVID-19, resulting in record levels of business formation.
One important concept these entrepreneurs should bear in mind when founding their company is the optimal business structure to form as. The most common include limited liability companies (LLCs), sole proprietorships, general partnerships, and corporations. While each entrepreneur’s situation is unique and will demand evaluation to produce an answer, for most people the safest bet is to start out as an LLC. This article will explore why.
Informal Business Structures
The two informal business structures are sole proprietorships and general partnerships – the only difference between the two is the number of owners. Where sole proprietorships have one owner, general partnerships have multiple. Neither of these business structures is formally organized, meaning the owners are personally liable for business debts or legal action made against it since the company’s taxes are filed under the owners’ names.
These structures are only really recommended for businesses that inherently involve very low risk. This normally means that it is very unlikely financial loss will be suffered, and if it is, it won’t be too significant. The greatest advantage this business structure has is its simplicity, though owners will have to decide whether this is worth the lack of personal liability protection.
The primary disadvantage of this business structure is its limited opportunity for growth. The reasons for this are twofold and work in tandem. Firstly, these structures cannot access the tax benefits of formal structures, meaning they pay self-employment taxes plus personal income tax on their net profit which significantly detracts from their profitability. Secondly, informal businesses are very unlikely to acquire credit from banks to help expand.
An LLC is the simplest legal business structure to form a company as that provides personal asset protection. On top of this, it also provides significant tax benefits that help retain a large proportion of its revenue. Both of these benefits will subsequently be broken down and explained in more detail.
This business structure places a demarcation between the assets belonging to the business and those belonging to its owners. This ensures that, as long as the owner maintains this separation between funds and ensures there is no crossover, his personal assets are considered off the table when it comes to repayment of the business’s debts or any legal action taken against it. In this way the owner’s personal assets are safe.
Additionally, since LLCs are regarded as ‘pass-through’ entities, they are able to save money on taxes. Put simply, all this means is that the LLC pays taxes through an individual income tax code, as opposed to a corporate one. Thus, it is not forced to pay corporation tax like other formal business structures. Websites like LLC University are worth checking out for their wealth of resources on how to form an LLC and other relevant topics.
While it will largely be more beneficial for most businesses to form as an LLC rather than a corporation, there are exceptions in which the opposite will be true. One of these exceptions is if the business will rely on outside investment now or in the immediate future.
Furthermore, if a business is left with large amounts of excess profit that it is unable to invest in itself by the end of the tax year, a corporation would be preferable in order to avoid the costly taxes on these idle profits. The reason for this is that these two structures are taxed quite differently.
Put simply, the carryover profits of LLCs are subject to a higher tax burden because its members must pay federal and state income taxes on top of FICA, which exceeds the 15% corporation taxes that corporations must pay.
On balance, business ownership can be a tricky challenge for new entrepreneurs to tackle, but they can make it much easier for themselves by choosing the optimal business structure for their needs.