Factors to Consider in Selecting a Business Type

Startup, Liability, Continuity, Taxes, Transfer, Profit/Loss

Startup
••• Types of Business - Factors to Consider. Xavier Arnau / Getty Images

You are ready to start a business and you want to select a business type. Use this list of factors to narrow down those that are important now and that may be important later. For example, the cost of startup is important now, but tax may be important later. Understanding the factors you consider most important will help you select a business type.

Sole Proprietorship

  • One owner. If you are starting a business with more than one person, you will need to form a partnership.
  • Complexity/Cost of Startup. You don't need to register your business with your state or prepare bylaws or operating agreements, but you will need to get a local business license.
  • Company legal record keeping/reporting complexity. No company records are needed, like an annual report or minutes of meetings. You don't have to pay an annual fee or report to a state regulatory agency. You must still keep good financial records.
  • Income tax. Schedule C, individual rate
  • Continuity - The business ends with the death of the owner or if the owner withdraws from the business.
  • Distribution of profits/losses - The owner receives all profits, absorbs all losses
  • Transfer of interest. The owner can sell at any time or transfer the business to another owner.
  • Tax position of the owner. The owner is self-employed, must pay taxes on the income of the business and must pay self-employment tax (Social Security and Medicare tax) on profits.
  • Ability to raise capital/get a business loan. Low; banks typically want a formal structure and liability protection from incorporation. To get investors, you will need a formal structure.
  • Separation of shareholders and managers. There are no shareholders, the owner and manager are the same person.

Partnership

  • Ownership. The business can have two or more partners and different types of partners.
  • Complexity/Cost of Startup. State registration, partnership agreement; attorney needed
  • Company legal record keeping/reporting complexity. Minutes of partnership meetings should be kept, and changes in the partnership agreement should be recorded. Some states require an annual report payment.
  • Income Taxes - The partnership files an information tax return, and individual partners pay income tax personally, based on their distributive share
  • Continuity - The partnership agreement should spell out what happens if a partner leaves. The partnership may dissolve if there is no agreement.
  • Distribution of profits/losses - Profits and losses are apportioned to individual partners based on the terms of the partnership agreement
  • Transfer of interest - Partners may sell or transfer interest, based on the partnership agreement
  • Tax position of individual owners - Partners are considered self-employed and pay self-employment tax on their individual shares of the partnership. Partners who work in the firm may be considered and paid as employees.
  • Ability to raise capital/get a business loan. You may be able to get a loan for a partnership; the limited liability partnership form is best.
  • Separation of shareholders and managers. General partners usually have management roles; limited partners have limited or no management roles.

Limited Liability Company (LLC)

  • Owners. An LLC can have one or more owners (called members).
  • Complexity/Cost of Startup. You must register your LLC with your state, create an operating agreement (with the help of an attorney).
  • Company legal record keeping/reporting complexity. Minutes of member meetings should be kept, as well as changes in the operating agreement. Some states require an annual or biennial report with fee payment.
  • Legal Liability - Liability of LLC members is limited to their investment in the business.
  • Income Taxes - An LLC with one member (called a single member LLC) is taxed as a sole proprietor; a multiple-member LLC is taxed as a partnership.
  • Continuity - Continuity if a member leaves depends on the provisions of the operating agreement. If a single-member LLC leaves, the LLC may be dissolved.
  • Distribution of profits/losses - Member shares of profits and losses are apportioned based on the operating agreement.
  • Transfer of interest - Members may sell their interest, based on the operating agreement
  • Tax position of individual/s - LLC members are considered self-employed and pay self-employment tax on the share of profits.
  • Ability to raise capital/get a business loan. Moderate. Banks accept LLC structure for loans. Investors want corporate structure.
  • Separation of shareholders and managers. There are no shareholders, but ownership is shared among the members. Some members may have management (employment) positions.

C Corporation

  • Ownership. Owners are shareholders; the number of owners is based on bylaws.
  • Complexity/Cost of Startup. The startup process is complex. It involves state registration, Articles of Incorporation, bylaws, issuing of shares of stock. and formation of a board of directors. An attorney is definitely needed.
  • Company legal record keeping/reporting complexity. Minutes of all board meetings must be kept, a corporate record book is required, and changes in bylaws must be recorded. Shareholders vote on some changes. Some states require an annual report, fee payment, or franchise tax.
  • Legal Liability - For liability purposes, a corporation a separate entity from the owners. Corporate officers may be personally liable.
  • Income Taxes - The corporation is taxed at the corporate rate. Shareholders pay income tax on dividends. (This is sometimes considered double taxation.)
  • Continuity - Continuity of the corporation is not affected by the loss of any one shareholder or director or executive.
  • Distribution of profits/losses - Paid to shareholders in form of dividends, based on the number of shares held.
  • Transfer of interest - Shareholders may buy/sell stock at any time unless restricted by agreement.
  • Tax position of individual/s - Owners working in a corporation are employees, not self-employed. If board members are paid, it is not as employees.
  • Ability to raise capital/get a business loan. Ability to get financing is excellent for both loans and investors.
  • Separation of shareholders and management. Shareholders may be executives but they are paid as employees.

S Corporation

  • Ownership. Not more than 35 shareholders (plus other eligibility requirements)
  • Complexity/Cost of Startup. An S corporation is formed by first creating a corporation then electing S corporation tax status. An attorney is definitely needed.
  • Company legal record keeping/reporting complexity. Minutes of all meetings should be kept, a corporate record book required, changes in bylaws must be recorded. Shareholders vote on changes. Some states require an annual report, fee payment, or franchise tax.
  • State registration. First, create a corporation, then register S corp election with the IRS.
  • Legal Liability - The corporation a separate entity, owners/shareholders are liable only to amount invested; officers may be personally liable.
  • Income Taxes - Corporate income tax is passed through to shareholders, based on stock held; generally no tax paid by the corporation
  • Continuity - Not affected by the loss of any one shareholder/director
  • Distribution of profits/losses - Paid to shareholders in the form of dividends according to investment
  • Transfer of interest - Shareholders may buy/sell stock at any time unless restricted by agreement
  • Tax position of individual/s - Owners working in a corporation are employees, not self-employed
  • Ability to raise capital/get a business loan. Excellent for both loans, investors.
  • Separation of shareholders and management. Shareholders who are executives have separate liability as employees.

A General Guideline for Business Type Selection At Startup

The type of business you start should match the complexity of your business.

  • If you are going to work from home and have no employees, you can probably start as a sole proprietor. If you want to look more official or you are worried about liability, start as an LLC.
  • If you are selling products, you plan on making these products yourself, and you plan to have employees, consider incorporating right away. You may want to change to S corporation status depending on your tax situation.
  • If you are going into business with another person, even your spouse, consider forming an LLC to limit liability or a limited partnership.

    Remember, you can always move up from a less complex business type to a more complex type as your business grows, you add employees, and your business becomes more profitable.