Starting a new business can be as exciting as it is confusing.

There are many things to consider when getting started: what products are you selling? How will you communicate with customers? What type of customers do you want to work with?

The ideal legal structure of a new business is one of the most popular questions that accountants and lawyers get when forming a new business. Do I need an LLC or corporation to start a business? Are there advantages or tax breaks that can come with a legal entity?

One of the most common misconceptions for new entrepreneurs is that forming a Limited Liability Company (LLC) is necessary to get started with a new business venture.

The IRS says that most people choose between four different legal structures when starting a small business: Sole Proprietorship, Partnerships, LLCs, and Corporations.

First, let's address the misconception that forming an LLC is necessary to start a business: While an LLC can provide certain legal protections, it is not a requirement for starting a business.

In fact, many small businesses start out as Sole Proprietorships, which is the simplest and most common business structure.

Sole Proprietorships

A Sole Proprietorship is a business owned and operated by one person. It's that simple!

If you don't choose to form a legal entity and instead start selling your product or service, in most cases, you're automatically deemed a Sole Proprietor.

According to the US Small Business Administration, Sole Proprietorships carry the least legal protection of any entity type. When it comes to sole proprietors, there is no legal distinction between the owner and the business, meaning the owner is personally responsible for all business debts, assets, and obligations.

Many Sole Proprietors choose to file a Doing Business As (DBA) form with their state. This allows you to keep the flexibility of being a Sole Proprietor while marketing and operating your business under a separate name.

For example, if Michael Scott starts a paper company as a sole proprietor, he can choose to operate as Michael Scott - plain and simple. Or, he can file a DBA and become "Michael Scott DBA Michael Scott Paper Company."

Fictitious business names allow Sole Proprietors to open up business bank accounts under their business name and receive payments and deposits to that business name.

While another name may refer to the business, Sole Proprietorships are not distinctly separate entities. This can be both a benefit and a drawback, as the owner has complete control over the business and assumes all the risks.

This can make it quite challenging to raise money for your business, bring in additional partners or employees, or receive a loan from a bank for startup capital.

Sole Proprietorships File Schedule C

As I mentioned, Sole Proprietors have no legal distinction between their personal assets and liabilities and business assets and liabilities - this is called "pass-through income." Income received as a Sole Proprietor is typically reported on the IRS form 1040 Schedule C.

Schedule C allows you to list the income and expenses that your business has incurred over the tax year. All businesses should work with a tax professional to file their Schedule C properly!

Partnerships

Partnerships involve two or more people owning and operating a business together.

Regarding partnerships, there are two types: Limited Partnerships (LPs) and Limited Liability Partnerships (LLPs).

In a Limited Partnership, there are both General Partners and Limited Partners. General partners are responsible for managing the business and assume all the liability ("unlimited liability") for the business's debts and obligations. In contrast, limited partners contribute capital but have limited liability.

This means that, in an LP, limited partners are distinctly separate from the obligations of the business but are still able to receive profit and other benefits. Many Private Equity funds, real estate investment vehicles, and other types of businesses are structured as Limited Partnerships.

In an LLP, all partners have limited liability, meaning they are not personally responsible for the actions of the other partners. Many professional service firms, like lawyers and accountants, structure their companies as Limited Liability Partnerships.

Partnership income typically flows through to the partner's personal tax return.

LLCs

LLCs are a hybrid between a Sole Proprietorship and a Corporation.

They are organizations that are primarily permitted under state statutes, which means that each state has different requirements for the LLCs operating within them. Regulations for LLCs vary between states.

LLCs offer personal liability protection like a Corporation but can be taxed like a Sole Proprietorship or Partnership. They're formed through state filings of Articles of Organization.

This means that LLC owners (referred to as members) are not personally responsible for the debts and obligations of the business. LLCs are typically "pass-through" entities. Still, they report business income and losses on their personal tax returns.

Many business owners register their business as an LLC for the flexibility and legal protection the business structure provides. They can be much easier to set up than corporations, provide more protection than Sole Proprietorships, and have options for tax elections.

LLCs can elect to be taxed as a corporation, partnership, or as a disregarded entity where income will pass through to the owner's personal tax return.  

Corporations

Corporations are the most complex business structure. They have a high administrative cost, can often come with their own tax liabilities, and can be challenging to maintain without proper advisors.

Corporations typically issue stock to their members, called shareholders. Ownership is often calculated based on the percentage of stock owned by each person or entity. Generally, shareholders are not liable for the debts of the corporation.

There are two main classifications of corporations: S-Corporations and C-Corporations.

S-Corps are treated as pass-through entities, with profits and losses passed to shareholders and reported on their personal tax returns. C-Corps are taxed on their profits at a corporate tax rate and are generally separate entities with more complex tax and reporting requirements.

Consult With a Professional

Each business structure has its own benefits and drawbacks.

Sole Proprietorships are simple and easy to set up but offer no personal liability protection.

Partnerships can offer more liability protection and allow you to be formally in business with someone else, but they require careful legal agreements to avoid disputes.

LLCs offer personal liability protection but can be more expensive to set up and maintain.

Corporations offer the most personal liability protection but have complex legal and tax requirements.

When choosing a business structure, it's essential to consider the business's and its stakeholders' goals and needs.

In addition to legal structure, there are other important factors to consider when starting a business. These include developing a business plan, choosing a name, and obtaining any necessary licenses and permits.

It's vital to seek a professional's advice, such as a qualified attorney, to ensure the business is set up correctly and legally compliant.

Starting a business doesn't necessarily require forming an LLC.

While it may provide some benefits, such as limited liability protection and tax flexibility, it also comes with drawbacks and costs. Sole proprietorships, partnerships, and corporations are all viable options with their own unique advantages and disadvantages and should be considered carefully before making a decision.

While a business's structure is important in the long run, the most difficult part of starting a business is bringing in sales and acquiring customers. Focus on growing your business first, then worry about things like forming an entity.

Don't get caught up in the hype of forming an LLC. Instead, focus on building a strong foundation for your business's success.

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Remember, this isn't tax or legal advice.

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Amarlo assumes no liability for actions taken in reliance upon the information contained herein.