One of the most important decisions you will make for your childcare business is the business structure you choose. Your business structure will have a significant impact on the way you run your childcare business, the paperwork you need to file, the taxes you pay, your personal liability, and your ability to raise funds. Your goal as a business owner is to choose a business structure that affords maximum tax benefits and minimum personal risk. In the following guide, we provide a basic overview of the different business structures available to you as a childcare business owner, including the highlights and drawbacks of each type of business structure.
What Is a Business Structure?
A business structure is simply the legal structure you choose for your childcare business entity. Each of the following types of business structures offers different levels of personal protection, mandatory paperwork, and taxation. Which business structure you choose will depend on your unique needs as a childcare business owner. Ask yourself:
- Do I need personal liability protection?
- Do I (now) or will I (in the future) need access to investor funds?
- Do I need my childcare business to operate as an entity independent of my involvement in the business (corporation)?
- What business structure will most benefit me in terms of taxation?
- How much business paperwork am I willing or able to file for my childcare business?
The answers to these questions may not be straightforward, and each business owner will need to consider his or her unique circumstances to make the best decision. Your professional tax accountant, as well as your legal advisor, will provide expert insight into your situation.
Ultimately, you will need to choose a business structure before you register your childcare business with your state. You may need to obtain a tax ID number and file for the necessary licenses and permits mandated by your state. Although it is possible to change your business structure later as your childcare business grows and your needs change, you may run into complications based on your location and legal limitations.
Let’s take a look at the common business structures from which you may choose.
Common Business Structures
The following business structures are considered informal business structures because they do not offer personal liability protection or tax advantages to the business owner(s):
Sole Proprietorship – A sole proprietorship is essentially a business owned by an individual that is not formally organized. The biggest advantage of a sole proprietorship is that it can be formed very easily at a low cost. Sole proprietorships are best for business owners who operate very low risk businesses and have a small customer base. Since sole proprietorships do not offer personal liability protection, the owner of a sole proprietorship will find his or her personal assets (house, car, bank account, etc.) at risk in the event that the business goes under or is sued. In addition, a sole proprietorship does not offer any tax advantages, as the business owner pays self-employment taxes as well as income taxes on the profits of the business. Because of these disadvantages, a sole proprietorship will be limited in its ability to grow and maximize profit. Finally, it is difficult to obtain a business loan or secure investors for a sole proprietorship, as lenders do not prefer to tie up money into these less-secure business entities.
Partnership – A partnership is a business structure that involves two or more individuals who share in the profits and losses of a business as agreed upon in a legally binding partnership agreement. A partnership may be a limited partnership (LP), in which only one partner has unlimited liability while the other partner(s) have limited liability, or a limited liability partnership (LLP) in which all partners have limited liability and are not legally responsible for the actions of the other partners. Either way, profits are passed through the business entity to the partners’ personal tax returns, and the general partner without limited liability also pays self-employment taxes for the business. As with a sole proprietorship, a partnership offers the partners no personal liability protection in the event the business is sued or defaults on debt and it does not afford any tax advantages.
Now we will take a look at the formal business structures, which do offer personal liability protection and tax advantages to the business owner(s):
Limited Liability Company (LLC) – A limited liability company (LLC) is a business structure that is somewhat of a hybrid of the partnership and corporation models. In an LLC, the business owner(s) are afforded protection against personal liability, meaning their personal assets (house, car, bank account, etc.) are not at risk in the event that the business goes under or is sued. Like the informal business structures, LLCs do not pay corporate taxes, but instead the profits and losses are passed through to the business owner(s)’s personal income taxes. Because the owner(s) of an LLC are considered self-employed, they must pay self-employment taxes. However, the LLC does offer a better tax advantage, as business owners with high profits can elect the S corporation tax classification, which may save the business money. (We’ll take a look at the S corporation tax classification later.)
Because of the personal liability protection and tax advantages provided by the limited liability company structure, these entities have great growth potential. In addition, LLCs have more credibility with both lenders and consumers, making it easier to obtain a bank loan, market the business, and more. LLCs are ideal for business owners who cannot afford to operate their business without personal liability protection and need a business structure that is easy to set up and maintain, while offering potential tax advantages.
LLCs require less administration and paperwork than corporations, but they can elect to become corporations in the future when needed.
Corporation (C Corp) – A corporation is a business entity that exists independently of the business owner(s) or founder(s). Just like an individual, a corporation can make a profit, be taxed, and be held legally responsible (sued). A corporation can be owned by shareholders and may be the right option for the business owner who wants to gain outside investors. A corporation offers the same personal liability protection as a limited liability company (LLC); however, it is more complicated and expensive to set up and maintain. A corporation is usually subject to strict compliance regulations and requires extensive paperwork and administration.
One of the disadvantages of a corporation is the potential for double taxation. Because a corporation is its own legal entity, it will be subject to corporate taxes. In some cases, a corporation will pay out taxes twice: once in the form of corporate taxes on its profits, and then again in the form of dividends paid to shareholders on their personal tax returns. Like LLCs, corporations may be able to elect the S corporation tax classification to avoid double taxation.
Corporations are a good option for business owners who want to attract investors or shareholders, raise money, “go public” with the company, and set up a business that exists independently of their involvement.
S Corporation (S Corp) – An S corporation is a corporation with a special tax classification that serves to offset the double taxation issue that owners of C corporations may face. In an S corporation all income and losses pass through the business directly to the shareholders on their personal tax returns. In this way, taxes are only paid out once, at the individual level, instead of on the corporate level first and then the individual level. In addition, an LLC can make an S corporation election if the following criteria are met:
- The business can pay the owner(s) a “reasonable salary” as outlined by the IRS
- The business meets all the requirements of S corporation status set forth by the IRS
The advantage of S corporation designation to an LLC is that it allows the business owner to be taxed as an employee of the company. As a result, the business owner pays self-employment taxes on the income he or she counts as wages but not on the income he or she counts as dividends. These distributions are only subject to income tax.
There are many nuances to the S corporation tax classification that pertain to both corporations and LLCs. If you are a business owner trying to determine whether your business is eligible to apply for S corporation status in your state, we recommend sitting down with your professional tax accountant or legal expert to determine the best course of action for your unique situation.
Choosing a business structure for your childcare business can be a confusing decision. The experts at Honest Buck Accounting are here to help. Schedule a call with us to chart the right course for your daycare company.