fbpx

Choosing the Right Business Structure for Your Creative Firm

Business Advice

Choosing the Right Business Structure for Your Creative Firm

Most of our readers are in the process of growing their creative businesses. Some are adding employees or launching product lines. Others are expanding into secondary markets or opening new studios. Growing your business is incredibly exciting, but it can also be a bit legally complicated. After all, with new opportunities come new risks. If planning to expand your business or already scaling up, it might be time to take a second look at its legal structure.

In this post, we take a look at the most common small business structures and consider which are best for creative companies. Some business structures legally separate the owner from their company while others offer very little liability protection. Which structure suits your business best depends on a number of factors. It depends on the size of your team, the type of work you do, where you work and what the future holds. From sole proprietorships to S-Corporations, follow below to learn all the pros and cons of different business structures as you prepare for growth. Curious why and when other business owners choose to change legal structures? Stay tuned for our upcoming post “When Should You Change Your Business Structure?”

Highlights: What Legal Structure Should My Business Be?

  • If you have never actively chosen a business entity, your business is probably structured as a sole proprietorship.
  • You can structure your business as a sole proprietorship, partnership or limited liability company LLC. If you choose to incorporate, you could structure your business as an S-Corporation, C-Corporation, Nonprofit Corporation or B-Corporation.
  • A corporation is a legal entity that is entirely separate from its owner(s).
  • The legal structure you choose determines how much you pay in taxes and how you file your taxes. It also determines how much you pay in fees.
  • Your business structure also determines how protected you are from debt, lawsuits and other liabilities.
  • Non-corporation legal structures have the fewest protections for business owners.
  • It’s fairly easy to reclassify as a corporation when you are a sole proprietor, but very difficult to transition back.
  • Reclassifying as a corporation could make it easier to obtain financing and develop other financial relationships.
  • Your tax burden probably won’t change much unless you choose to reclassify as a C-Corporation.

Answering Your FAQs About Small Business Legal Structures

What is a Business Structure?

If you have always operated as an independent contractor, you might not know what your business’ legal structure is. You might not even know what a business structure is! So what is a business structure?

Your business structure is not the same as its organizational structure. Joshua Stowers explains in an article for Business News Daily. According to Stowers, a business legal structure or business entity “is a government classification that regulates certain aspects of your business.”

If you typically fill out Schedule C of Form 1040 when filing your taxes, your business is currently structured as a sole proprietorship. The legal structure of your business has tax implications on both a federal and state level. It can also have personal liability implications for the business owner.

Legal structures authorized by all fifty US states include sole proprietorships, Limited Partnerships, Limited Liability Partnerships, Limited Liability Corporations, S-Corporations, C-Corporations and Nonprofits. Some states also recognize B-Corporations and Co-Ops.

When Do You Choose a Legal Structure?

Business owners should choose a legal structure before registering their business with the appropriate state or local agency. You will need the documents used to register your business when applying to open a business account. As such, business owners should settle on a legal structure before applying for business licenses, permits and/or accounts.

A CPA, accountant or attorney can help you determine which legal structure is appropriate for your business. Most creative companies start as sole proprietors – the default tax status for business owners – or partnerships and later incorporate when business picks up. Keep in mind that operating expenses go up as the complexity of your tax structure increases – even if your individual tax burden diminishes.

How Do You Change Your Business’ Legal Structure?

Curious how you change your business structure? This chart maps out exactly how to change your business structure.

It is much easier to change legal structures from sole proprietorship to partnership to LLC to corporation than to do the reverse. Basically, it is more difficult to simplify the legal structure of your business than it is to increase its complexity. Here are the steps to changing legal structures in most states:

#1 Consult an attorney or CPA to review changes in liability, insurance coverage and tax burden if desired

#2 Fill out legal forms or draw up legal documents signaling the change in status

Note: These forms and documents might include IRS forms, a Partnership or Operating Agreement, Articles of Organization or Incorporation and/or Bylaws.

#3 Appoint a Board of Directors and/or Officers

Note: This step is only required for businesses changing their tax structure from a sole proprietorship, partnership or LLC to a corporation or nonprofit. If changing your structure from an SP or partnership to an LLC, you can appoint a BOD. However, it is not legally required to do so.

#4 File all necessary documents with Franchise Tax Board, Secretary of State and other government agencies

Note: The number of forms you must file with the Tax Board or SOS increases as the complexity of your structure increases. Fees incurred also generally increase as the complexity of the legal structure increases.

#5 Pay all fees

Note: Fees incurred also generally increase as the complexity of the legal structure increases.

#6 Transfer assets and liabilities from your current business to the new business

Note: This might occur automatically upon filing paperwork with your state or county, but some business owners must manually transfer assets and liabilities.

#7 Update your EIN

Note: According to the IRS, changing the tax structure of your business requires you to obtain a new EIN or Employer Identification Number. Changing the name of your business or relocating that business does not usually require you to obtain a new EIN.

What Are the Different Types of Legal Structures?

Sole Proprietorship

Many businesses begin as sole proprietorships. It is the default classification for businesses that are not officially registered as a partnership, LLC or other legal structure. You need not register as a sole proprietorship to be considered one legally. However, you might need a business license to operate in your state, county or city.

There are very few — if any — fees involved in either forming or maintaining a sole proprietorship. Unlike other business structures on this list, sole proprietorships are not separate legal entities from their owners. Business owners file all profits and losses on their personal tax returns.

A sole proprietorship business structure affords the owner absolute control over all business decisions, but does not provide any type of liability protection. It can also be difficult to fundraise as a sole proprietor. According to this resource from the U.S. Small Business Association, “you can’t sell stock [as a sole proprietor].” Banks and other financial institutions are also more “hesitant to lend to sole proprietorships.”

Sole proprietorships typically make the most sense for business owners who are just starting out. If you have minimal personal assets and are at a low risk of being sued, a sole proprietorship might work for you.

Defining Features of a Sole Proprietorship

  • Sole proprietorships are not legally separate from their owners.
  • They are easy and inexpensive to form.
  • The business owner is liable for any claims made against the business and vice versa.
  • Sole proprietors must pay self-employment tax on their net income, but there is an SE tax deduction. The SE tax rate is currently 15.3%.
  • Sole proprietors are required by the IRS to pay estimated quarterly taxes throughout the year.

Which Forms Do You Need to File Taxes as a Sole Proprietorship?

When filing taxes as a sole proprietorship, you must submit IRS Form 1040 — typically with Schedule C filled out. Schedule C outlines your business’ profits and losses for the last tax year.

Limited Partnership (LP)

Next on our list of business structures is the limited partnership. An LP is a partnership between general partners and limited partners — sometimes called “silent partners.” General partners participate in the everyday management and decision-making involved in running their shared business. Limited partners do not participate in such management activities; their influence is typically commensurate with their investment.

While general partners are able to make important decisions about how the business is run, they also bear all responsibility for the business. In his article “Limited Partnership: What It Is, Pros and Cons, How to Form One” for Investopedia, Evan Tarver explains. Tarver writes that “the general partner of a limited partnership has unlimited liability for the debt.” Limited partners — on the other hand — “have limited liability up to the amount of their investment.”

General partners are also required to pay self-employment taxes, while limited partners are exempt. According to Tarver, limited partnerships are usually “used as investment vehicles for investing in such assets as real estate.” Like sole proprietorships, limited partnerships are pass-through entities, but business owners are required to register them in most states.

You will likely need a partnership agreement – sometimes called an “operating agreement” – that outlines the duties, investments, compensation and liability of each partner. Though uncommon, your state, city or county might require that you submit this agreement to the government.

Defining Features of a Limited Partnership

  • Limited partnerships are fairly easy and inexpensive to form.
  • LPs have very few reporting requirements compared to corporations.
  • Limited partners have limited personal liability, but general partners do not. General partners are personally liable for business debts.
  • While general partners absorb all the risk involved in managing the business, they also have complete control over its trajectory.
  • The IRS considers limited partnerships “pass-through” entities.
  • Both limited and general partners could qualify for a 20% pass-through tax deduction.
  • Partners are required by the IRS to pay estimated quarterly taxes throughout the year.
  • Profits and losses are allocated to limited partners based on their investment in the business.

Which Forms Do You Need to File Taxes as a Limited Partnership?

When filing taxes as a partnership, both limited and general partners must submit IRS Form 1065 and IRS Form 1040. General partners should fill out Schedule SE on Form 1040. Check this resource from the IRS for more information or discuss your options with an accountant.

Limited Liability Partnership (LLP)

The next business structure on our list is the limited liability partnership or LLP. There are several important distinctions between a limited partnership and a limited liability partnership. The first distinction is that all partners in a limited liability partnership (LLP) can participate in day-to-day decision-making.

The second is that every partner has limited liability. Each partner is protected from errors made by the other partners or complaints lodged against them. A group of doctors who start a practice together might choose an LLP for this very reason.

Most states require business owners to register their limited liability partnership with a government agency. According to Andrew Beattie in an article for Investopedia, forming an LLP “requires a written partnership agreement and usually comes with annual reporting requirements.” Reporting requirements vary by location.

Defining Features of a Limited Liability Partnership

  • LLPs provide all partners with liability protection from the actions of and claims against other partners and the business as a whole.
  • Not all states recognize LLPs as separate legal entities. This can curb an LLP’s effectiveness at protecting partners from lawsuits and other legal claims.
  • An LLP is a pass-through entity.
  • All partners functioning as general partners must pay SE tax.

Which Forms Do You Need to File Taxes as a Limited Liability Partnership?

Partnerships must file IRS Form 1065, while each individual must file Form 1040 with Schedule E and/or Schedule SE. They might also need to file Form 965-A.

Limited Liability Company (LLC)

Unlike LLPs, limited liability companies or LLCs are recognized in all fifty US states. Like an LLP, an LLC protects each member’s personal assets from debts, lawsuits and other claims made against the business. Limited liability companies can be owned and operated by a single individual or by partners. Those who choose to structure their business as an LLC must file articles with the appropriate state government. They must also obtain a business license, which is required for some LPs and sole proprietorships too.

According to Priyanka Prakash in an article for NerdWallet, LLCs are often chosen by business owners who want “a lot of flexibility.” Prakash writes that “the owners of an LLC can decide their management structure, operational processes, and tax treatment.” The owners of an LLC can choose whether their business will be taxed as a pass-through entity or as a corporation. As the federal corporate tax rate currently sits at 21%, it might make more sense for high earners to choose the latter when filing. However, the corporate tax rate is scheduled to change under the Inflation Reduction Act.

Defining Features of a Limited Liability Company

  • LLCs provide personal liability protection to all owners/partners.
  • Limited liability companies have annual reporting responsibilities and must register with state government agencies — typically the Secretary of State.
  • LLCs can be owned and operated by a single person, by a partnership or by a group.
  • Owners of LLCs can choose a corporate tax structure if they wish. Both S-Corp and C-Corp structures are available to owners of LLCs. They can also choose to be taxed as pass-through entities.
  • Tax requirements differ from state to state. For example, LLCs in California must file Schedule K-1 (Form 568). If owners opt for a corporate tax structure, they must file Form 100 or Form 100S. California differentiates between LLCs structured as S-Corps and LLCs structured as C-Corps when determining state income tax.
  • An operating agreement might be required.
  • Members typically pay SE tax.

Which Forms Do You Need to File Taxes as a Limited Liability Company?

The tax forms you file as the owner(s) of an LLC depend on how your LLC is classed. If your LLC is structured as a partnership, you will file different forms than if it is structured as a C-Corp. According to this resource from the IRS, “a domestic LLC with at least two members is classified as a partnership.” Just like LPs and LLPs, partners represented by an LLC should file Form 1065, U.S. Return of Partnership Income.

In order to be taxed as a corporation, the owners must file Form 8832, Entity Classification Election with the IRS. Those who file as a corporation must submit Form 1120, U.S. Corporation Income Tax Return. If you do not file as a corporation, you can record business profits and losses on your personal tax return. LLCs taxed as pass-through entities will file Form 1040, U.S. Individual Income Tax Return.

S-Corporation

S-Corporations provide business owners with liability protection and a number of tax benefits not provided by LLCs, LLPs and other types of corporations. Like sole proprietorships, partnerships and certain LLCs, S-corporations are pass-through entities. This means that they do not pay corporate taxes, which C-corporations must.

In order to qualify as an S-Corp, businesses must meet a number of criteria set by the Internal Revenue Service. According to this resource from the IRS, a corporation must be domestic, “have only allowable shareholders,” and “have no more than 100 shareholders.” It can only have a single class of stock.

Like other corporations, S-Corps have specific reporting requirements. In her article “Characteristics of an S Corporation” for the Houston Chronicle, Laura Reynolds explains. Reynolds writes that S-corps “transfer income, losses, deductions and credits to their shareholders in transactions called distributions” instead of paying corporate taxes. As such, each S-corporation must “file annual federal tax returns reporting income and distributions.” Every S-corp must also file “reports and tax returns as required in the state or states where they are chartered.”

S-Corps must also file articles of incorporation with the appropriate state government in order to operate as such. Fees related to filing paperwork, issuing reports and hiring attorneys can make forming and maintaining an S-Corp more expensive than other business structures.

Defining Features of an S-Corporation

  • S-Corps offer personal liability protection to all owners.
  • S-Corporations have a simplified tax structure that makes filing easier — and often less expensive — for business owners.
  • S-Corps are pass-through entities; they rarely pay federal corporate income taxes.
  • Unlike C-Corps, S-Corps that issue stock can only issue one type of stock. There are also limitations on the number and type of shareholders. Foreign investors are rarely permitted, and S-Corps are typically limited to no more than 100 shareholders.
  • The way in which dividends are allocated to shareholders is strictly regulated.
  • Business owners must file paperwork with state governments and the IRS if they want their business to be taxed and structured as an S-Corp. In most states, these include Articles of Incorporation. This resource from UpCounsel identifies everything you might need to form an S-Corp.
  • S-Corp owners typically pay SE tax, but this burden can be lessened. According to an article from Investopedia, “by characterizing money they receive from the business as salary or dividends,” S-corps can reduce SE taxes.
  • Structuring your business as an S-Corporation could make it appear more credible to lenders and investors. However, this classification does draw more attention from the IRS.
  • As separate entities, S-Corps are fairly easy to sell, restructure and/or pass on to new owners.
  • S-Corps are subject to certain bookkeeping rules.

Which Forms Do You Need to File Taxes as an S-Corporation?

As noted above, business owners who wish to classify their LLC as a corporation must submit a specific form to the IRS. Similarly, those who want their business taxed as an S-Corporation must file IRS Form 2553. From Form 1120-S to Form 1040, this resource from the IRS lists all you might need to file as a shareholder of an S-Corporation.

C-Corporation

The next business structure on our list is the C-Corporation. Unlike S-Corporations, C-Corporations allow business owners to accept foreign investment and have more than a hundred shareholders. C-Corps can also issue multiple classes of stock. This makes them attractive to different types of investors that might not be interested in an S-Corp. From partnerships to foreign corporations, C-Corps can accept investment from pretty much anyone.

Beyond the potential for outside investment, C-corps also provide business owners with a certain level of liability protection and many tax deductions. However, business owners cannot deduct business-related expenses on their personal tax return. As noted above, a C-Corp business structure can be attractive to high-earning companies.

Unfortunately, C-corporations are subject to double taxation. This means that shareholders pay income tax at the corporate level and at the individual level. However, not all dividends are taxed in the same manner, which this resource from Investopedia explains in further detail. Other disadvantages of the C-Corp business structure include intense scrutiny from the IRS, strict reporting responsibilities and hefty start-up costs.

Defining Features of a C-Corporation

  • Business owners need not pay self-employment tax.
  • Income is subject to double taxation, but there are many deductions available to corporations. However, business assets and expenses cannot be claimed on your personal income tax return.
  • C-Corps can be expensive to form and maintain. They are also highly regulated.
  • Type and number of investors is not restricted.
  • Multiple classes of stock are allowed.

Which Forms Do You Need to File Taxes as a C-Corporation

According to this resource from the IRS, you must file Form 1120, U.S. Corporation Income Tax Return. You might also need to file Form 1120-W and Form 940, 941 or 943 with the IRS. Shareholders must file Form 1040 to report personal income from dividends.

Other Business Structures You Might Not Have Considered

The final three business structures on this list are less common in the interior design industry, but might be found in other creative industries. For example, the B-corporation business structure is gaining popularity with owners of sustainable homeware marketplaces and regenerative travel companies. Cooperatives can make sense for individual makers — i.e. textile designers, graphic designers, ceramicists and other fine artists — without their own studio staff.

Nonprofit Corporation

A nonprofit corporation is not the same as a 501(c)3 nonprofit organization. According to this article from the Houston Chronicle, “a nonprofit corporation is formed the same way as a for-profit corporation.” However, one must also obtain “tax-exempt status from the IRS.” Nonprofit corps cannot issue stock or have shareholders. Benefits differ based on classification. Some nonprofit corps are classed 501(c)(6) while others are 501(c)(4).

B-Corporation

A B-Corporation is a corporation that “benefits” certain causes and is held to strict ethical standards. Not all states in the US recognize B-Corps. According to this post from Dickinson Law’s Inside Entrepreneurship Law blog, B-corps are “businesses that operate in a socially and environmentally responsible manner.”

Cooperative

A co-op is a business structure that functions more like a partnership or sole proprietorship than a corporation. The primary focus is supporting cooperative members — not delivering returns to investors. According to Abigail Orencia in an article for Fit Small Business, “co-ops are organized to provide competition, improve bargaining power [and] reduce costs.”

Membership benefits include equal status, lower risk, tax advantages and “social benefit.” As for the tax benefits, Orencia notes that “a co­operative society is exempt from income tax up to a certain limit.” However, financing opportunities are limited.

How is Your Business Structured?

How is your creative business currently structured? Are you a sole proprietor or have you chosen to structure as an LLC, S-Corp or other type of corporation? Would another legal structure be more appropriate for your growing business? Let us know in the comments below or start a dialogue in our private Facebook group.

Still curious about how LLCs, S-Corps and other business structures compare to each other? Download our free Business Structure Comparison Chart for more information!

0 Comments

Submit a Comment

Your email address will not be published.

Laura Umansky

I'm Laura

As an inerior design business owner, I understand how challenging this industry can be and how hard it is to find success. For the past 15 years, I have grown my award-winning firm from a party of one (just me!) to a talented team of over 20, with two brick-and-mortar studios. And through it all I experienced set backs and the loneliness that comes with being an entrepreneur. That’s why I’m sharing all my tips and tricks on the blog. Success shouldn’t be a secret. Find your reliable path to sustainable, profitable growth right here.

U

Browse

DON’T FORGET

Download my 10-step checklist and find out if you’re ready to grow your design business

These are the top things you must consider before you start on your growth journey.