Deciding how your business will be structured is one of the very first decisions you will make as an online business owner. It involves both legal and tax considerations. And that’s because your selected business structure will dictate not only how your business functions but how its profits are taxed. There are some basics that you NEED to know before choosing a business structure.
Know that that everything I chat about here is intended to provide legal information and education. It is not business, financial, or legal advice, and does not create an attorney-client relationship between us. I’m an attorney licensed in the United States, so everything will be from the perspective of United States law. You should consult with an attorney in your area who understands your particular business situation so that you can take the right steps for you and your business.
(And if you’d like a general overview of the legal issues you should consider for your online business, snag a copy of An Online Entrepreneur’s Guide to Starting a Business).
A sole proprietorship is the simplest (and most common) business structure. There are no formal steps to take and there is no cost to form a sole proprietorship. You become a sole proprietor the moment your business activity commences.
As a sole proprietor, you and your business are one and the same. You are entitled to all business profits and you are also personally liable for everything you do in your business, including business debts and obligations. One way to limit your liability is to purchase liability insurance.
All profits (or losses) for a sole proprietorship are reported on your personal tax return vis-a-vi your Schedule C.
Like a sole proprietorship, you do not need any formal legal documentation to form a partnership. HOWEVER, people who only informally agree to do business with each other often run into problems later down the road. The best practice is to create a Partnership Agreement (especially since the law can presume a partnership in certain situations if you agreed to share profits and liabilities). A partnership agreement will address things like the distribution of profits, decision-making, and what happens if you want to dissolve the partnership.
It’s important to note that you don’t have to be a natural person to form a partnership (i.e., 2 corporations can also form a partnership).
Like a sole proprietorship, partners are personally liable for everything they do in their business. Partners can protect themselves by purchasing liability insurance.
The partnership “passes through” its profits to the partners and each partner pays the taxes on their individual share of those profits, i.e. pass through taxation. Similarly, if the partnership took a loss for the year, each partner can deduct their share of the loss from their personal tax return.
Under United States law, corporations are viewed as separate people (which means they can be held legally liable – and offer protection to the owners from personal liability). For instance, when you sign a contract for your business, you want to make sure that it is your company entering into the agreement and not you personally. You can read more about why written contracts are so important here.
Unlike sole proprietorships and partnerships, there are a lot of formalities to both form and maintain a corporate structure.
Corporations generally require:
- A Certificate of Incorporation (which is the license to form a corporation issued by the State);
- Articles of Incorporation (like a Constitution for your business that is filed with the State when you incorporate); and
- Bylaws (the rules for the internal management of your business).
Every corporation must have a Board of Directors and it is required to hold regular meetings – record-keeping is a cornerstone of the corporate structure. But corporations also have a leg up when it comes to raising capital because they can issue stock to do so.
Note that business incorporation is state specific, so you want to be sure to check your state’s incorporation requirements.
Corporations feature double taxation – they are required to pay income tax on any profits; and when distributions are taken, they will pay taxes on those as well (unless the corporation makes the S-Corp election).
A corporation may make the S-Corp Election within 75 days of incorporating OR within 75 days of the beginning of its fiscal year. This lets the IRS know that rather than double taxation, your corporation chooses pass through taxation (so that income and some losses flow through to the owners’ personal returns).
To qualify for the S-Corp Election:
- Shareholders may not be partnerships or corporations
- Shareholders must be US citizens or residents
- There must be 100 shareholders or less
- There can only be one class of stock
- The business’s profits and losses must be allocated in proportion to ownership interest
- All shareholders must consent to the election
It’s important to note that a business that opts to be taxed as a S-corporation is required by the IRS to pay owners a reasonable salary. This can be done by a payroll company (and there are many affordable online payroll companies these days).
Piercing the Corporate Veil
Limited liability is not an impenetrable shield! In some circumstances, even though a corporation has been validly formed, the courts will hold the shareholders, officers, or directors personally liable for corporate obligations because the corporation is abusing the legislative privilege of conducting business in the corporate form (aka the courts will pierce the corporate veil).
One reason? If the business owners fail to maintain separation between their personal finances and the corporation’s finances. If the lines become blurred, the courts will find that the corporation is not to be considered a separate person.
The long and short of it? You want to make sure you follow the rules to avoid losing your corporate status.
LIMITED LIABILITY COMPANY
Since setting up a corporation can be expensive and requires a lot of formalities, many business owners who wish to limit their liability form a Limited Liability Company (LLC) instead.
LLCs are the simplest form of a corporation. They are like a partnership in that they have decentralized control (member managed instead of by a board of directors), but they also have limited liability like a corporation (only the LLC is liable for the debts and liabilities incurred by the business, not the individual owners).
Single owner LLCs can opt to be taxed as sole proprietorship or a corporation.
Multiple owner LLCs can opt to be taxed as a partnership or a corporation.
If an LLC opts to be taxed as a corporation, it can choose between filing taxes as a C-Corporation or an S-Corporation.
Courts use roughly the same standards for piercing the LLC veil as for piercing the corporate veil – remember to keep your business and personal finances separate!
So, there you have it, the business structure basics.
You can obtain further information about business structures and their formation on your state’s Secretary of State website. And be sure that you’re looking into your state’s licensing and permit requirements while you’re at it 😊