How should you structure your business?
Which form of organization (sometimes referred to as 'business entity") will be best for your business? Two key features to consider in structuring your business are liability protection and desired tax treatment. You should discuss the best business entity for your situation with an attorney who will describe the legal ramifications and assist you with the filings and an accountant who can provide you with tax advice on the different types of business entities.
There are several ways to form a business including sole proprietorship, partnerships, corporations, limited liability companies, and limited liability partnerships. When choosing a business entity to consider liability protection, taxes, management structure, ownership transition, and capitalization.
The sole proprietorship is a popular and frequently used form of business organization. It is an unincorporated business owned by a single individual. When your business is organized as a sole proprietorship, your personal and business affairs are merged together. As the proprietor, you own and control the business. From the standpoint of nearly all legal rights and responsibilities, your sole proprietorship business and you, as the owner or proprietor, are considered to be one and the same.
- Inexpensive to start
- Simple to run
- No double taxation on profits
- The owner has unlimited personal liability and/or business liabilities
- The business has unlimited liability for the owner's personal liabilities.
- Ownership is limited to one person.
A partnership combines one or more individuals or businesses as co-owners under a partnership agreement. The agreement should be in writing and determine the powers, liabilities, and authorities of each partner. The lack of a written agreement can result in extremely damaging conflicts between partners when a disagreement arises. There are two forms of partnership: The General Partnership and the Limited Partnership.
General Partnerships – In this type of agreement, the income and expenses of the partnership are directly taxable to each individual general partner based on his/her proportionate interest in the firm. The partnership files an information tax return and pays no separate business income tax. Even a well-crafted partnership cannot completely protect against a partner acting outside the scope of the agreement and incurring debts and liabilities that become the responsibilities of the other partners.
Limited Partnerships – In a limited partnership, "limited" partners have protection against obligations of the firm beyond their initial investment, as with a corporation. Limited partnerships must have at least one general partner responsible for all the debts, liabilities and obligations of the firm. A limited partner should not take an active role in the business and risks becoming a general partner by doing so. In a limited partnership, most partners limit their liability while keeping their rights to participate in profits and/or tax advantages.
- A flexible form of business
- Permits ownership by more than one individual
- Avoids double taxation.
- Few legal formalities for its maintenance
- General partners have unlimited personal liability for business losses.
- The partnership is legally responsible for the business acts of each general partner.
- General partnership interest may not be sold or transferred without the consent of all partners unless otherwise agreed.
- Partnership dissolves upon the death of a general partner
A corporation is a separate legal entity, distinct from its owners with rights, duties, powers, and responsibilities in and of itself. The corporation may enter into contracts, own personal property, and real estate, and sue and be sued. As a result, the stockholders of a corporation assume no personal liability for the debts of the business. The risk is limited to the amount of the investment the owners make in the firm. The limitation on personal liability is one of the chief benefits of forming a corporation. A stockholder may sell his or her interest in the company without first obtaining the approval of other stockholders unless they agreed otherwise. A corporation can continue to exist indefinitely regardless of whether investors or owners quite, die, or declare bankruptcy.
On the special type of corporation of interest to small businesses is the Subchapter S corporation. This type of corporation avoids double taxation by having its income taxed to the shareholders as if the corporation were a partnership. It also allows the shareholders to have the benefit of offsetting business losses incurred by the corporation against the income of shareholders. However, you must contact the Internal Revenue Service (IRS) office to have the corporation specifically recognized as a sub "S" corporation.
- Provides limited liability to owners
- Easy to transfer ownership.
- Easy to add additional owners/investors
- More costly to set up and maintain.
- Requires separate tax returns.
- Subject to double taxation
Limited Liability Companies (LLC)
An LLC combines many of the advantages of a corporation with many advantages of a partnership. Like a corporation, An LLC is a separate and distinct legal entity. LLCs can obtain a tax identification number, open a bank account, and do business, all under its own name. Like a partnership, there is no double taxation and more tax flexibility than a partnership. A primary advantage of an LLC is that its "members" (owners) are not personally liable for the debts and liabilities of the LLC. If the assets of the LLC are not enough to cover the debts and liabilities, the creditors generally cannot look to the members, managers, or officers for recovery. Having a formal written operating agreement lends credibility to your LLCs separate existence.
- Recognized as a separate legal entity from its members
- Shields members from individual liability
- Avoids double taxation of profits.
- More costly to set up and maintain than a general partnership or sole proprietorship.
- More paperwork and documentation.
Limited Liability Partnerships (LLP)
The LLP is a type of general partnership offering certain unique advantages. An LLP can be formed so that all partners can participate in the management process. Income is not taxed to the LLP, but is instead "passed-through" and taxed to the partners at their individual tax rates, much like a general partnership is taxed. LLPs offer broader financial protection for partners by setting rational limits to the exposure of out-of-pocket expenses and insulating the personal assets of one partner from other partners' misconduct. Other than a one-time filing of a registration statement no other annual filings are required.
A nonprofit corporation forms for purposes other than generating a profit and in which no part of the organization's income is distributed to its directors or officers. A nonprofit corporation can be a church or church association, school, charity, medical provider, legal aid society, volunteer services organization, professional association, research institute, museum, or in some cases a sports association. Nonprofit corporations must apply for tax-exempt status at both the federal and state level.