Resource: Business Structures
Business types and structures
Alright! You're finally starting your own business. Now how are you going to structure it? You might not know but there are several business structures to choose from. Each has its own list of pros and cons, including the complexity of formation, liability protection, and tax implications.
Below you will find a quick overview of the most common business types. Please keep in mind that if you are still unsure of which is the best structure for you, then please consult with an attorney. I prefer LawTrades.com for a quick, easy, yet effective solution.
Lots of entrepreneurs start with a sole proprietorship or general partnership (and then potentially switch to a different structure once their business expands). Sole proprietorships are the simplest type of business organization to establish. In fact, you don't really have to do anything to become a sole proprietor (though your local government may require a license before you can do business). You don’t need to complete any public filings or take any formal steps to create a sole proprietorship.
A sole proprietorship is not considered to be a separate legal entity from its owner. The business's legal name is your name, and its profits and losses are included on your personal tax return. Sole proprietors have personal liability for business debts and lawsuits.
Sole proprietorship pros
- They're the easiest and least expensive form of business entity to organize.
- Sole proprietors are in complete control and may make decisions by themselves (within the parameters of the law, of course).
- Sole proprietorships can be easily converted into another type of business entity in the future.
Sole proprietorship cons
- Unlimited liability: the owner will be held personally liable for all debts against the business.
- Because of the unlimited liability, sole proprietorships may be at a disadvantage in raising funds.
- The business entity dissolves upon the retirement or death of the owner.
Sole proprietorship tax structure
- Taxation of income: Directly to the owner.
- Self-employment taxes: Yes.
- Tax forms: 1040.
A partnership is an agreement in which two or more people agree to share in all assets and liabilities of a business. With a general partnership, the law does not distinguish between the business and its owners (just like a sole proprietorship). Each owner has unlimited personal liability and full authority to conduct business for the partnership.
You don't need to file documents with the state to form a business, but you will need to get an EIN (employer ID number) as your tax ID and many states require that you register your DBA ("doing business as" name). Most partnerships also create a written partnership agreement with details on how you'll make decisions, resolve disputes, and allocate profits and losses.
General Partnership pros
- Low start-up costs.
- Pass-through tax treatment: Like in a sole proprietorship, no taxes are paid at the business level. Instead, the individual partners are taxed on the income they receive from the partnership. Each partner pays taxes on their share of the business income on their personal tax returns.
- Limited regulation.
- Broader management base and flexibility of financing.
General Partnership cons
- Unlimited liability: partners will be held personally liable for all debts against the business.
- Authority is divided.
- It might be difficult to raise funds.
- A general partnership will end upon the bankruptcy, withdrawal, or death of any of the partners.
- Taxation of Income: Directly to partners.
- Self-employment taxes: Yes.
- Tax Forms: 1040.
A note on other partnership types
In addition to general partnerships, you can also form limited liability partnerships and limited partnerships. These partnerships are generally more complex to form than a general partnership, and they offer liability protections that general partnerships do not. Keep in mind that the requirements and formation process varies from state to state. My advice here, seek an attorney.
Limited Liability Companies (LLC)
LLCs are the most flexible of all incorporated business entities. They're a relatively new type of business structure that's specific to the US. An LLC is more complex to form than a general partnership but can be easier to form than a corporation.
LLCs are a legal structure that's governed entirely under state law, rather than a federal tax structure. That means LLCs can choose to be taxed like a corporation or to have pass-through taxation like a partnership or sole proprietorship.
- LLCs have great organizational and managerial flexibility.
- The liability of a member of an LLC is limited to the member’s personal investment in the company.
- LLCs offer the ability to choose your tax structure.
- LLCs do not have to follow some of the corporate formalities that apply to corporations.
- LLCs tend to have a much more complex tax filing system than other entities.
- Tax and liability treatment of LLCs is not uniform across state lines.
- LLC owners must elect how they want to be taxed by the IRS (e.g. as a sole proprietorship, partnership or corporation).
- Self-employment taxes: Depends on the tax status of LLC.
- Tax Form: Depends on the tax status of LLC.
A corporation is a legal entity that is separate and distinct from its members (shareholders). A corporation can acquire assets, go into debt, enter into contracts, sue, or be sued. Ownership interests in a corporation are usually easily changed. Shares may be transferred without affecting the corporation’s existence or continued operation.
There are two types of corporations (C corp and S corp), with differences in taxation and corporate ownership.
- Limited liability.
- Possible tax advantage (if you qualify for a small business tax rate).
- Ownership is transferable.
- It's easier to raise capital.
- The most expensive form of business to organize.
- Possible double taxation of profits.
- Corporations must continually observe corporate formalities that can be time-consuming and costly, e.g., holding periodic board meetings and annual shareholder meetings and abiding by various record-keeping requirements.
- Corporations are monitored by federal, state and some local agencies, and may have more paperwork than other types of businesses.
- Taxation of income: Depends if you are a C or S corp.
- As a C Corp, you are taxed once at the corporate level and again as individuals.
- As an S corp, business profits are taxed as personal income of shareholders.
- Self-employment Taxes: No, since payment for employment is in the form of wages.
- Tax form C Corp: IRS Form 1120.
- Tax form S Corp: IRS Form 1120S, shareholders get K-1 for personal tax.
As you can see, there is a lot to consider here. This of course depends on what you are doing and how all is involved. Again, use this as a resource and not a guide. If you need a guide with forming your business then seek legal assistance.
Hero photo by Ylanite Koppens