Chapter 5

Types of business structure

Your business structure can affect how much tax you pay, and how you're treated by the law.

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Business structures and their effects

Most small businesses are structured as a sole proprietorship, partnership, limited liability company (LLC) or S corp. Your choice will affect your admin burden, tax and legal status.

If you don’t choose a business structure

If you don’t choose a structure when starting a business and are the only business owner, you’ll be considered a sole proprietor. That’s how a lot of people start out. However, it’s worth understanding what it means to be a sole proprietor, and getting your head around the other structures. Speak to a lawyer or accountant before making any decisions.

What is a sole proprietorship?

A sole proprietorship is a single-owner business. It doesn’t have to be a single-worker business, so you can hire staff.

Advantages of a sole proprietorship

It’s easy to set up as a sole proprietor and tax is simple. You just declare income on your personal tax return.

Disadvantages of a sole proprietorship

A sole proprietorship doesn’t have any special legal status, which means the owner is personally responsible for what the business does. If the business gets into debt or legal trouble, so does the owner. Having proper insurance is very important.

What is a partnership?

A partnership is owned by two or more people. There are no rules about how it’s divided. One partner can own 99% of the business.

Advantages of a partnership

It’s easy to set up as a partnership, but it’s best practice to get an official letter that sets out the agreement between partners, with help from a lawyer. Tax is simpler too. The partnership files its tax return, and then the items from that return flow to the partners’ personal tax returns.

Disadvantages of a partnership

If the business gets into financial or legal strife, the partners do too. You could also get into difficulty if one of the other partners does something wrong. Having proper insurance is very important.

What is an LLC (limited liability company)?

An LLC is legally separate from its owner (or owners), which means you’re less exposed to legal or financial risks. LLCs are the most common type of new entity formed today, since they have flexible options for ownership and taxation. An LLC can be owned by one person or many. If there is more than one owner of the LLC, having a partnership agreement is a good idea.

Advantages of an LLC

You may get some legal and financial protection if things go wrong – a lawyer can give you the lowdown. And tax can be relatively simple if you’re taxed as a sole proprietor or S corp.

Disadvantages of an LLC

It will cost you more to operate as an LLC than as a sole proprietor or partnership, plus there will be more admin.

LLCs and tax

If you’re an LLC with one member, the IRS will treat you as a sole proprietorship by default. If you have more than one member, you’ll be treated as a partnership. Or you can elect to be taxed as a corporation or S corporation.

What is an S corporation (S corp)?

An S corporation is not a business structure but a tax designation. An S corporation is an LLC or corporation that has chosen to be taxed as a “pass-through” entity. It can have 100 or fewer shareholders and only individuals, and some other types of entities, can be shareholders.

Advantages of an S corporation

The primary benefit of forming an S corp is avoiding double taxation. An S corp typically doesn’t pay corporate taxes. Income is passed directly to its shareholders and they pay taxes at their own income tax rates. Since it's a legal entity, you get some legal and financial protection if things go wrong – a lawyer can give you the lowdown.

Disadvantages of an S corporation

The legal side of incorporation and IRS compliance can get quite complex. There’s a lot of admin and paperwork to do.

You can change your business structure

A lot of businesses start out as sole proprietorships and grow into LLCs or corporations. You might change your business structure if you start getting bigger and doing more complex projects which carry a greater financial or legal risk for you.

Where do franchises fit?

If you buy into a franchise, you don’t automatically become part of their business. You form your own business and enter into a deal with the franchisor. You may be able to choose your own business structure, or the franchise agreement may require it to be set up in a specific way, such as an LLC.

Disclaimer

Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the provided content.

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