It’s important to seek professional advice when making this decision, but it’s also important to have a general understanding of the choices available. There are basically six options.
1. Sole Proprietorship
A sole proprietorship is the simplest and most common way of organizing a business. A sole proprietorship is not a separate legal entity. It simply refers to a person who owns and runs a business. For legal purposes, there is no difference between the business and the sole proprietor in a sole proprietorship.
-Ease of Formation
Sole proprietorships are easy to form. The owner does not need to file any formation documents with governmental agencies, except for a “DBA (doing business as)” certificate if it plans on doing business under a different name than the owner. Sole proprietorships are also very inexpensive to form since there are no organizational documents, no legal fees for drafting documents, nor are there any filing fees.
Because the sole proprietorship is indistinguishable from its owner, there is no double taxation, which means that all profits and losses for the business are handled on the owner’s personal tax returns. This means that the net income from the business is only taxed once.
-Unlimited Personal Liability
The biggest downside of a sole proprietorship is that the owner is personally liable for all of the business’ activities, including its liabilities and debts. This means that the owner’s personal assets, like their house and savings accounts, could be seized to satisfy court judgments.
-No Stock Options
A sole proprietorship also cannot issue equity (stock options) to employees or investors.
There is no continuity of existence with sole proprietorships. Upon the death or incapacity of the owner, the sole proprietorship ceases to exist.
2. General partnership
A general partnership is a business entity that is made up of two or more entities to carry on a trade or business. Each partner contributes money, labor, property, or skills and each partner shares in the profits and losses from the business.
-Ease of Formation
Forming a GP usually only involves registration with the state and paying a small fee. And though it’s recommended that the partners draft a partnership agreement laying out the terms under which the partnership will operate, it’s not required by law.
A general partnership is a “pass-through” tax entity, which means that the income and losses of the business are “passed through” to the individual partners. In other words, the partnership itself does not pay any income tax on its profits. Instead, the partners report their share of profits and losses on their individual income tax returns.
-Independence of Partners
Each partner has the ability to act independent of the other partner(s), which allows the business to respond quickly to problems by lowering the red tape involved in decision-making.
-Unlimited Personal Liability
Both the profits and losses of the business are shared equally by all partners. This also means that all the partners are personally liable for business debts and liabilities, like a judgment in a lawsuit. This means that if the business itself can’t pay a creditor, the creditor can legally come after any partner’s house, car, or other possessions.
Taking part in a general partnership means that you also agree to let every other person make decisions on your behalf and on behalf of the business, and that you agree to take full responsibility for those decisions.
3. Limited Partnerships
Limited partnerships (LPs) are a cross between a general partnership and a limited liability company. An LP provides protection to the limited partners (aka silent partners), but not the operating partners, or the general partners. The limited partners receive profit distributions, but do not take an active role in the day-to-day operations of the business.
Like general partnerships and sole proprietorships, limited partnerships are also “pass-through” tax entities, which means that the income and losses of the business are “passed through” to the individual partners, and the limited partnership itself does not pay any income tax on its profits.
-Losses Limited to the Total Money Invested for Limited Partners Make it Easier to Raise Money
One of the key benefits of a limited partnership is that typically the limited partners can’t lose more money than they invested. This makes it much easier for new businesses or investment projects to raise money because the investors aren’t as afraid of losing money for the company’s mistakes.
-Limited partners get to share in the profits and losses without having to participate in the business itself
-General partners are personally fully liable for the debts of the business
While the limited partners enjoy limited liability and typically will only lose the amount of money they invested in the business, the general partners are completely at risk.
A corporation is a legal entity that is created to conduct a business. It’s a separate entity from those who founded it, which handles the responsibilities of the organization. The law recognizes corporations as people, and so a corporation can be taxed and held legally liable for its actions. A corporation can also make a profit.
-Shareholders are not personally liable for the debts of the corporation
When it comes to taking responsibility for the debts and actions of a corporation, shareholders’ personal assets are protected. Shareholders generally can only be held accountable for their investment in the stock of the company.
-Can issue stock
Corporations can raise funds more easily than other types of business entities because they can issue stock. They can also offer stock and stock options for employees, which is especially appealing for larger businesses. Offering potential partial ownership of a company is attractive, and it helps companies draw in good employees.
-A clearly established power and management structure
There are directors, officers, and shareholders. Each group has its own set of clearly-defined roles and responsibilities.
-More costly and time-consuming to start and maintain
Corporations require operating, start up and tax costs that other business entities do not require. For instance, you have to file Articles of Incorporation and the filing fees can be expensive.
All corporations are required, by law, to do a number of things, like hold regular meetings of the directors and keep records of corporate activity, to ensure that the corporation is acting as a separate entity.
The profits of the corporation are taxed as they are earned at a corporate level, and the profit is also taxed to the shareholders when it is distributed out as dividends.
5. S Corporations
S corporations derive their name from Subchapter S of the Internal Revenue Code which provides corporations a tax election option, or a choice on how they want to be taxed. Under Subchapter S, a company may elect to pass all of its profits to its shareholders directly. Meanwhile the limited liability benefits of the corporation continue. So it’s sort of like the best of both worlds: the advantage of limited liability provided by a corporation with pass-through taxation that a typical corporation doesn’t enjoy.
A corporation must meet certain requirements to be eligible for a subchapter S election. It must have no more than 75 shareholders (a husband and wife count as one shareholder), and only the following entities may be shareholders: individuals, estates, certain trusts, certain partnerships, tax-exempt charitable organizations, and other S corporations.
-Limited Liability With Pass-Through Taxation
Income is taxed only at the shareholder level, not at the corporate level, which means S corporations avoid the double taxation that some corporations face. Also, shareholders are not personally liable for the debts of the corporation. If the corporation fails, the shareholders are liable for their investments, but are not personally responsible for the corporation’s debts.
As a separate structure, S corps require scheduled director and shareholder meetings; minutes from those meetings; adoption and updates to by-laws; stock transfers and records maintenance.
-Shareholder Compensation Requirements
A shareholder must receive reasonable compensation in an S corporation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results.
6. Limited Liability Company (LLC)
An LLC is viewed as a hybrid between a partnership and a corporation because it offers the limited liability of a corporation, but has the tax benefits of a partnership. LLCs are one of the most popular choices on this list.
-Liability of the members is limited to the amount of their investments
Members are only liable to the extent of their investments in the company. Unlike with a sole proprietorship or a general partnership, creditors cannot pursue personal assets (house, savings accounts, etc.) of the owners to pay business debts.
Like general partnerships and sole proprietorships, limited liability companies are also “pass-through” tax entities, which means that the income and losses of the business are “passed through” to the individual partners, and the LLC itself does not pay any income tax on its profits.
-An LLC can have just one member
-There is no limit on the number of members for a LLC
LLCs are still a new option in most states (they exploded in the 1990’s, but previously were very uncommon). This means that the law governing LLCs is still evolving, and there is very little case history in the courts to determine how these laws will be interpreted.
Most states require that an LLC’s Operating Agreement set a limit on the company’s existence (usually 30 years). Also, in many jurisdictions, if a member departs the LLC, the LLC ceases to exist. This is unlike a corporation whose identity is unaffected by the comings and goings of shareholders. However, if there’s a clause in the Operating Agreement that says the LLC will continue on in the event of a death or withdrawal of a member, this weakness can be combated.
Thoughts on Choosing the Proper Business Type
Three good questions to ask when choosing an entity for your business are:
1. Who will be the business owners?
2. How does the business expect to distribute profits to its owners?
3. Is the business expected to generate profits or losses in the early stages?
For instance, if the business is owned by one individual who does not plan to add ownership interests, then the management structure is not of particular concern. The owner’s decision will depend more on tax considerations and personal liability protection.