When starting your own business, one of your first decisions will be selecting a type of entity to form. The entity you choose will greatly influence how much personal liability you assume, how you will be taxed, how you are obligated to compensate your employees, and more. As such, taking the time to talk with a qualified attorney and determine the best option for your business is a vital step you should not skip.
In this blog, we will share an overview of the five most common entity structures. While we will cover the basics, you should consult an experienced business planning attorney before making a final decision and filing your corporate paperwork. The five most common entity structures are:
A sole proprietorship is when someone owns and runs a business by themselves. That business is unincorporated. This structure is the simplest and easiest to understand. To form a sole proprietorship, you won’t need to complete any formal entity formation filing with the federal government. Entity formation filing is separate from business licenses; you must obtain one in order to sell any service or goods. If you remain the only owner, you are a sole proprietor for as long as you are selling your services. For example, a freelance writer who works alone is a sole proprietor. When it comes to taxes, there is no differentiation between you and your business, so you are taxed as one and will use a Schedule C and a Standard Form 1040.
The only fees involved are those required for the business licenses and permits required by the state in which you live and operate. Additionally, there is no limit to the amount of people that you can have working for you in a sole proprietorship. One significant drawback is that the owner of the sole proprietorship is personally responsible for all debts of the business. There is no separation of the business and the person, so if something happens to the business and it cannot meet its obligations, creditors can come after your personal assets (car, home, bank accounts) to cover the debts. It can be harder to get a loan or line of credit from a bank because of this personal liability.
A partnership is an association of two or more persons, known as general partners, who act as co-owners of a business and operate it for profit. Every state has specific laws on the formation and dissolution of partnerships, as well as laws regarding the legal responsibilities of each partner. Partnerships need only file an information return (a form indicating the partnership's income, expenses, and profits or losses) with the Internal Revenue Service, but the partnership itself does not pay taxes. Each partner pays federal, state, and local taxes on their income from the partnership as if it were personal income.
For a partnership, the partners must have a partnership agreement; if the business is intended to last for more than one year, the agreement must be in writing. However, it is always a good idea to have the partnership agreement in writing no matter what. The partnership agreement must contain: the name of the partnership, the names of each partner, a general description of the type of business the partnership will conduct, the financial contributions of each partner, how profits and losses will be divided, how partners can leave the business and how new partners can be added, what steps must be taken to dissolve the partnership, and the powers and duties, including limitations or restrictions on a partner.
Like the sole proprietorship, each partner is personally responsible for the debts of the partnership. There can be shielding of one partner in a limited partnership. A significant disadvantage to a partnership is that either partner in a general partnership can decide when it is over and end the business. In a limited partnership, only the general partner can end the partnership and the limited partner is along for the “ride”.
C Corporations are what most people generally think of when they think of a corporation. It is a very well regulated, monitored entity. There are strict requirements at both the state and federal level to starting a C Corp. They are considered separate entities from the owners of the business. The corporation can own property, be taxed separately, and be held legally liable for debts and crimes. Corporations must have a board of directors, stock (private or public), and extensive record keeping, operational processes, and reporting. Corporations can raise capital easier than sole proprietorships and partnerships because they can sell stock (albeit, it is heavily regulated) and apply for loans or lines of credit separately from the owners. One drawback to C Corps. is double taxation, meaning both the Corporation and shareholders are taxed. The corporation is taxed on all profits, and then when dividends are paid to the shareholders, those are taxed as well.
S Corps. are a special type of corporation designed to avoid the double taxation of the C Corp. Some profits and losses are passed through directly to owners’ personal income without being subject to corporate taxes. All S Corps start as C Corps and must file with the IRS to obtain S corp status in addition to registering with their state. Similarly, S Corps have a separate identity from the owners in that if shareholders leave or sell their stocks, the corporation will continue.
A Limited Liability Company, or LLC, is a hybrid entity between the sole proprietorship and a corporation. There can be one or many members of the LLC; like a partnership, there should be an LLC agreement. LLCs have the pass through income of a partnership/proprietorship, but the liability shielding of the separate entity status of a C/S corp. You can decide if the LLC will be taxed as a corporation or as a partnership; however, members of LLCs are considered self-employed and must pay the associated taxes. LLCs must file tax returns if they are taxed as corporations, but if that option is not elected, members will file personal tax returns.
To wrap up, selecting the most appropriate structure type may have a large impact on your new business. Taxes, personal liability, and simplicity are just a handful of pros/cons to consider when making the decision. An attorney can help to ensure you are setting up your business for success while putting the proper legal safeguards in place.
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