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Start It Up

Choosing the structure for your new business

Alvin Fritschle

By Alvin Fritschle

Alvin Fritschle is the Chairman of the Board of First Bank, a community bank serving Southeastern Illinois and Southwestern Indiana. He has provided financial advice to numerous entrepreneurs for over 40 years as a certified public accountant and the President of First Bank. Over this time, he has demonstrated a strong commitment to assisting his clients with their strategic decisions.

Deciding on a legal structure is one of the most critical choices you will make when starting your own business. This decision should be made only after consulting with legal counsel and your tax advisor.

When selecting the legal structure of your new business, there are several factors you need to consider.

  1. Legal Liability: What extent do you wish to shield yourself from the legal liability of your new company? You must decide the level of risk associated with the new company and if you can afford to absorb that risk personally.
  2. Tax Implications: Based on your goals for the future of the business, what are the opportunities to minimize income taxes?
  3. Cost: Does the cost associated with forming a corporation exceed the tax benefit and risk of personal liability? What is the extra cost of accounting and tax preparation?
  4. Flexibility: Is one of your goals to maintain the maximum amount of flexibility in running the business, or are you willing to give up some flexibility to save on your taxes? Are you planning to have investors in the company?

The following is a summary of the various types of legal structures most commonly adopted by new businesses. Each business is unique, and we cannot recommend one over another for you. Only choose a legal structure after consulting your legal counsel and tax advisors.




Sole Proprietorship

This is the simplest type of business structure. Generally, the business is owned by one individual who also works in the business. If you do nothing in selecting a form of business structure, you automatically become a sole proprietorship under the law. Sole proprietorships are the most common form of legal structure for new businesses because of the ease and low cost in setting it up.

Pros of a Sole Proprietorship

  • Easy and inexpensive to form.
  • Your taxes will be relatively easy; simply complete a Schedule C and attach to your 1040.
  • If you have a business loss it can be deducted on your personal tax return.
  • Minimal paperwork required.
  • Most flexibility for the owner in how they handle their money.
  • Can have employees.

Cons of a Sole Proprietorship

  • You assume full liability for all business liabilities and legal risk. There is no separation of business and personal assets.
  • It may be more difficult to obtain small business loans. Lenders like to see complete accounting records that separate personal and business expenses.
  • It will be more difficult to raise money from investors. Since you cannot transfer partial ownership of the business to investors, they are less likely to invest in your company.



General Partnership

This is a good choice if your new business is going to be owned by more than one individual. With a general partnership, the owners manage the company and assume the legal responsibility for all of the partnership’s debts and legal risks.

Pros of a General Partnership

  • Similar to a sole partnership, general partnerships are easy to form. While a partnership agreement is not required, you are encouraged to do so. The partnership agreement will lay out the expectations for each partner and how assets will be split should the partners decide not to work together any longer.
  • Like a sole proprietorship, general partnerships are taxed as “pass through” entities. All income and losses are passed through to the partners’ individual tax returns.
  • The legal risks are shared by partners.
  • Limited paperwork required. While a partnership agreement and partnership tax return are required, corporate registrations and on-going minutes are not required.

Cons of a General Partnership

  • Be careful to select partners you trust and can work with over time. Since each partner can commit a general partnership to liabilities, they can impact your personal assets and credit scores.
  • Each partner is individually liable for all of the partnership’s debts and liabilities. Liability for partnership liabilities is not on a pro-rata basis.
  • Each partner may become liable for the negligent act of another partner.
  • Disagreements among the partners can force the business to be liquidated. Partnerships are like marriage--some do not last over time.



Limited Liability Corporations (LLC)

Limited liability corporations are a hybrid business structure with characteristics from both partnerships and corporations. Like corporations, LLC offers the owners limited liability protections. However, they are similar to partnerships in that they do not require as much paperwork as a corporation. This is a common structure for consulting businesses such as accountants, attorneys, engineers, and financial advisors.

Pros of Limited Liability Corporation (LLC)

  • Owners are not personally liable for the business’s debts or liabilities.
  • This is a “pass through” entity for tax purposes with income and losses deductible on the individuals’ income tax returns.
  • A member of the LLC can be an individual, a partnership, or a corporation. Members have a percentage of ownership like a partnership.
  • Profits and losses do not have to be distributed in the same percentage as the money put into the LLC.
  • Less paperwork than corporations.

Cons of Limited Liability Corporations (LLC)

  • It is more expensive to create an LLC than a partnership, including incorporation expenses and state registrations.
  • Since there are no stock certificates, it is tougher to attract investors or raise public money. It will also be harder to transfer ownership.
  • It is more difficult to provide fringe benefits to the owners like medical insurance and retirement plans.
  • As with a partnership, LLC members must pay self-employment taxes on income from the LLC whether it is distributed or not.



C Corporations

Using a C corporation as your corporate structure is more complex and expensive than other types of business structures. A C corporation is legally considered to be an independent entity that is separate from its individual owners. Because of this separate legal status, there are more regulations and taxation is more complex.

Pros of a C Corporation

  • C corporations offer the greatest protection for personal assets from the liabilities of the business. Since a C corporation is considered a separate entity, the personal assets of the owners are generally shielded from the company’s liabilities.
  • C corporations have an easier time raising capital from investors. For example, C Corporations can sell stock to investors that can easily be transferred to new owners at a later date.
  • C corporations’ income taxes are filed separately from the individual owners of the company, and income not distributed to the owners is not subject to the self-employment taxes.

Cons of a C Corporation

  • C corporations are more complex and expensive to set up.
  • C corporations have less flexibility. They require formal recordkeeping of shareholder meetings, board meetings, annual corporate registrations, and compliance with articles of incorporation and by-laws.
  • Distributions of earnings to investors as dividends may be subject to double taxation.
  • Business losses in the corporation cannot be deducted on the individual owners’ tax returns.



S Corporations

S corporations are similar to C corporations in that they shield the individual shareholder’s personal assets from the liabilities of the corporation.

Pros of a S Corporation

  • Offers all the advantages of C corporations, but the income of the business is passed through to individual shareholders and there is no double taxation of business income.
  • Unlike with a partnership, undistributed earnings of the S corporation are not subject to self-employment taxes.

Cons of a S Corporation

  • There are limits to the number of investors who can own stock in the corporation.
  • Trusts cannot own stock in the corporation.
  • S corporations have the same recordkeeping requirements as C corporations.



Summary

The selection of your business structure is a complex decision that you should not make on your own. After reviewing the pros and cons of each option, we recommend that you consult your legal and tax advisors. Ready to take the next step? Check out the next resource in this series: “Preparing the One Page Lean Business Plan.

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