Running and owning a business is difficult enough, but one of the most consequential decisions you’ll have to make is finding the business entity type that best suits your company’s goals and operations. Your business entity type is your company’s official classification in the eyes of the state, and it affects things like how much you’ll pay in taxes, what documents to file, or how much you’re personally liable against instances of lawsuits or bankruptcy. There are several different types of business entities—they can even be combined in certain cases—and while choosing the right one is important, it isn’t necessarily permanent.
Why Change Your Business Type?
Reclassifying your business after gaining employees, offering new services, or scaling down is common in the business world, and can have long-term positive effects for your company. However, it can have unintended tax consequences, so it’s important to tread carefully. The biggest differences between the various business types often comes down to different tax levels and protections in the case that your business is sued or declares bankruptcy. There are pros and cons to each, however. An S or C Corporation offers the most legal protection for business owners, for example, but is also subject to tighter regulations and fees.
The most common types of businesses are Sole Proprietorship, Partnership, Limited Liability Company (LLC), and Corporations (taxed as S or C). Each one has specific requirements that need to met by the business owner, so it’s especially important that terms of each class are understood. You may find that the best business structure for taxes also requires you to provide a good or service your business can’t source.
Business classification is subject to laws at both the federal and state levels, and business owners without formal legal training may find it difficult to navigate the legal pathways available. Consulting an attorney that specifies in corporate business structure ensures that business owners have all of the necessary information to make an informed decision about the future of the company. Qualified small business tax accountants can also provide a better description of the kinds of tax liability in place for each business type as well.
What are the Different Business Structures?
Before considering restructuring, business owners should at least familiarize themselves with the most common structures available:
Sole proprietorships are easy for individuals to form, and offer the most control over the business. They can be a good choice for low-risk business owners who want to test a product or idea before upscaling. However, sole proprietors have very low legal protections against lawsuits or bankruptcy, and the business owners can be held personally liable for damages or debts owed. Sole proprietors also can’t sell stock, and some banks are hesitant to lend to businesses of this type. Sole proprietorships and single member LLC’s operating as sole proprietorships also have the highest risk of audit with the IRS.
Partnerships are the simplest structure for two or more people to own a business together. There are two common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP). The two distinctions grant different levels of liability to different partners, and they can be a good choice for businesses with multiple owners.
Limited liability company (LLC)
An LLC lets business owners take advantage of the benefits of both the corporation and partnership business structures. LLCs separate your business and personal assets for the sake of liability, meaning you won’t lose things like your house or vehicle in the event of bankruptcy or lawsuits. LLCs are also exempt from corporate taxes, but usually require the owner to pay self-employment tax. They’re a good option for owners with personal assets they want to protect, and owners who want to pay a lower tax rate than they would with a corporation.
A single member LLC (SMLLC) would be taxed as a sole proprietorship, and a multi-member LLC (MMLLC) would be taxed as a partnership.
A corporation is a legally separated entity from its owner, and can continue to do business with or without the owner. Hence, the owner is not legally liable for the actions of the corporation—in most cases. Corporations offer the strongest protection in terms of personal liability, but the cost to form a corporation is higher. Corporations also require extensive record-keeping, operational processes, and reporting. By default, corporations are taxed as a C corporation, which pays it’s own taxes.
S corporations, which you must make an election with the IRS, are designed to avoid the double taxation that often happens with C corps. S corps allow profits, and some losses, to be passed through directly to owners’ personal income without ever being subject to corporate tax rates. Corporations are the right choice for large businesses with many employees, shareholders, or large assets.
Is my Business Classification Right for me?
There are many different factors to consider when classifying or reclassifying your business. Your goals as a business owner have to be weighed with the realities of your operation—including the state in which you incorporate, income levels, or services provided. This is especially true after a major shift in the business, like gaining or losing a partner, buying corporate real estate, or in the aftermath of a lawsuit. It can help to make a list of current assets and inventory, and weigh it against the kind of benefits needed to support business growth. You can start by asking yourself questions like:
- What’s my current tax rate?
- Can I deduct Qualified Business Income (QBI) on my personal tax return?
- What level of outside investment am I looking for?
- What age would I like to retire?
- Do I plan on selling the business one day?
- How many employees do I need?
- Does the owner(s) want to paid as an employee?
- How prepared am I for a lawsuit or bankruptcy?
Questions like this can help you see the bigger picture when it comes to what you want out of your business, but professional guidance from business councilors, attorneys, and accountants can grant you peace of mind that you’ve thoroughly considered all your options.
How to Reclassify your Business
The actual restructuring process can differ from state to state and could have adverse tax consequences if not planned for properly. There are a few basic steps you can take on your own.
- Registering in the state you live in or want to be incorporated in will differ, but many sole proprietorships will be able to skip this step.
- You may be required to get a new Employee Identification Number (EID) to legally distinguish the organizational shift, as well as a DBA. This stands for “Doing Business As” and it is the business name that is presented to the public. It may be different from the business name legally registered to the state.
- Alert any state or local tax agencies to the change in your classification, as well as any relevant licensing or permitting authorities relevant to your business.
- You’ll also want to let your customers, partners, or vendors know about the change as well, and if there are any implications for them.