Choosing the right business structure is an important part of starting a new business and will likely be one of the first decisions entrepreneurs make. The chosen business structure will affect taxes, liability, ability to raise capital, ownership succession and other factors.
When making this decision, it is important to seek the professional advice of a lawyer and accountant or other consultant, as the chosen structure will have long-term implications for the business.
There are four basic business structures and the links below detail the positive and negative elements of each:
- sole proprietorship
- Corporation: Subchapter S Corporation
- Limited Liability Company (LLC)
The vast majority of small businesses start out as sole proprietors. These businesses are owned by a single person, usually the person who has the day-to-day responsibilities of running the business. Individual owners own all the assets of the business and the profits generated by it. They also assume full responsibility for any of your liabilities or debts. In the eyes of the law and the public, you are in business.
Advantages of a sole proprietorship:
- This is the easiest and least expensive form of ownership to organize.
- Individual owners are in full control and, within the parameters of the law, can make whatever decisions they see fit.
- Individual owners receive all income generated by the business to maintain or reinvest.
- Profits from the business flow directly to the owner's tax return.
- The business is easy to dissolve if desired.
Disadvantages of a sole proprietorship
- Sole proprietors have unlimited liability and are legally liable for all debts incurred against the business. Your business and personal assets are at risk.
- Homeowners may be at a disadvantage in obtaining funds, and individual homeowners are often limited to using funds from personal savings or consumer loans.
- These companies have a hard time attracting high caliber employees or those who are motivated by the opportunity to own a piece of the business.
- Some employee benefits, such as owner's health insurance premiums, are not directly deductible from business income (they are only partially deductible as an adjustment to income).
In a partnership, two or more people share ownership of a single business. As with property, the law makes no distinction between a business and its owners. Partners must have a legal agreement that sets out how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted into the partnership, how partners can be purchased, and what steps will be taken to dissolve the partnership. society. when necessary Yes, it is difficult to think about separation when the business is just starting, but many companies break up in the middle of the crisis and, if there is no defined process, the problems will be even greater. It must be determined in advance how much time and capital each will contribute.
Advantages of a partnership
- Associations are relatively easy to establish; however, time must be invested in developing the partnership agreement.
- With more than one owner, the ability to raise funds can be increased.
- Profits from the business flow directly to the partners' personal tax returns.
- Potential employees may be attracted to the business if they are encouraged to become partners.
- The company will often benefit from partners who have complementary skills.
Disadvantages of a partnership
- Partners are jointly and individually responsible for the actions of other partners.
- Profits must be shared with others.
- As decisions are shared, disagreements can arise.
- Some employee benefits are not deductible from business income on tax returns.
- Society may have a limited life; it can end with the retirement or death of a partner.
Types of associations
- Association in general -The partners share the responsibility for management and liability, as well as the share of profits or losses in accordance with their internal agreement. Equal parts are assumed, unless there is a written agreement to the contrary.
- Limited Liability Company and Limited Liability Company –Limited means that most partners have limited liability (to the extent of their investment), as well as limited involvement in relation to management decisions, which generally incentivizes investors for short-term projects or for investments in capital assets. This form of ownership is not often used to operate retail or service businesses. Forming a limited partnership is more complex and formal than a general partnership.
- consortium -A joint venture (JV) acts like a general partnership, but it is clearly for a limited period of time or a single project. If the partners of a temporary union repeat the activity, they will be recognized as a permanent company and must file as such, as well as distribute the accumulated assets of the company when the entity is dissolved.
A corporation chartered by the state in which it is based is considered by law to be a single entity, separate and separate from those who own it. A corporation can be taxed, it can be sued, and it can enter into contractual agreements. The owners of a corporation are its shareholders. Shareholders elect a board of directors to oversee major policies and decisions. The corporation has a life of its own and is not dissolved when ownership changes.
Advantages of a corporation
- Shareholders have limited liability for corporation debts or judgments against corporations.
- In general, shareholders can only be held responsible for their investment in shares of the company. (Note, however, that directors may be personally liable for their actions, such as failure to withhold or pay employment taxes.)
- Companies can raise additional funds by selling shares.
- A corporation can deduct the cost of the benefits it provides to executives and employees.
- A corporation can elect S corporation status if certain requirements are met. This election allows the company to pay taxes similar to a partnership.
Disadvantages of a corporation
- The incorporation process requires more time and money than other forms of organization.
- Corporations are monitored by federal, state, and some local agencies and may have more paperwork to comply with regulations as a result.
- Incorporation may result in higher overall taxes. Dividends paid to shareholders are not deductible from business income; therefore, you can pay twice.
Subchapter S Corporations
An S corporation (S-corp) is just a tax election; This option allows the shareholder to treat the income and benefits as distributions and transfer them directly to their personal income tax return. The problem here is that the shareholder, if he works for the company, and if there is a profit, must pay himself wages and must meet "reasonable remuneration" standards. This can vary by geographic region and occupation, but the general rule is to pay yourself what you would pay someone else to do your job, as long as there is enough profit. If you do not, the IRS may reclassify all earnings and gains as wages and you will be responsible for all employment taxes on the full amount.
A limited liability company (LLC) is a hybrid type of legal structure that provides the limited liability characteristics of a corporation and the tax efficiency and operating flexibility of a partnership. The owners of an LLC are called members. Depending on the state, members can be a single person (an owner), two or more people, corporations, or other LLCs.
Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, the company transfers all profits and losses to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just as partnership owners would.
Like a corporation, an LLC can also apply for S-corp status. The organization remains a limited liability company from a legal standpoint, but is treated as an S-corp for tax purposes. For more information on the advantages and disadvantages of S-corps status for LLCs, visit the SBA website.
Advantages of an LLC
- Members are protected from personal liability for business decisions or actions of the LLC.
- This means that if the LLC goes into debt or is sued, the members' personal assets are generally exempt. This is similar to the liability protections offered to shareholders of a corporation. Remember that limited liability means "limited" liability: members are not necessarily protected against wrongful acts, including those of their employees.
- The operational ease of an LLC is one of its biggest advantages. Compared to an S-corp, there is less registration paperwork and lower start-up costs.
- There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members can contribute different proportions of capital and sweat.
- Consequently, it is up to the members themselves to decide who has made what percentage of profit or loss.
Disadvantages of an LLC
- In many states, when a member leaves an LLC, the business is dissolved and the members must comply with all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or separate. However, provisions can be included in operating agreements to extend the life of the LLC if a member decides to leave the business.
- Members of an LLC are considered self-employed and must pay self-employment tax.