Choosing what type of business structure to use is not as simple as deciding whether you’d rather have Inc. or LLC after the name. You’ll need to take legal, tax and paperwork implications into consideration before deciding if your business should be a sole proprietorship or a corporation. Here’s a brief breakdown of four common business structures.
With a sole proprietorship, an individual is the sole owner and all business decisions rest with him or her and, in some cases, the spouse. A sole proprietorship is the easiest business structure to set up.
From a legal standpoint, the owner and the business are one and the same. The owner is personally responsible for all business debts and lawsuits. Despite the legal liability, taxes are easier to figure out; income and losses are filed with personal taxes at personal tax rates.
There are two types of partnerships: general partnerships and limited partnerships. In both, two or more people partner to form a business, but in a limited partnership one individual is in charge and runs the business while the other partner(s) is nothing more than a passive investor. General partnerships are easier to setup and run than LLCs and corporations, though doing business as a limited partnership can be just as complicated as a corporation.
If two business owners chose to file as a partnership, then they are both personally liable for all business debts and obligations. If one is the general partner and the other is the limited partner, the former is personally liable for all debts and obligations, and the latter only liable for the money they’ve invested. With both types of partnerships, profits and losses are filed with both partners’ personal taxes.
Limited Liability Company
Limited liability companies are basically a combination of corporate and partnership business structures. LLCs are founded by an owner or owners, called members (like a partnership), but the owners enjoy limited legal liability (like a corporation). Starting and running an LLC is easier than for corporations, but more complicated than sole proprietorships and partnerships.
With an LLC structure, the members, in most cases, aren’t personally responsible for the business’ debts or obligations. That doesn’t apply if a member does something fraudulent or illegal, personally guarantees a business loan or debt, treats the LLC as an extension of personal affairs or personally injures someone. LLC owners file taxes as individuals.
Corporations are treated as separate entities from their owners. Corporations issue stock to shareholders in exchange for money, property or both and are the most complicated business structure. There are two main types of corporations: C and S corporations, and both offer legal liability similar to an LLC.
With C corporations, income and losses are reported on a corporate tax return, which are separate from the owners and shareholders. This means that profits are taxed on the corporate return and then taxed again when paid out to shareholders as dividends. Shareholders report the dividends on their personal returns — a form of taxation known as double taxation. However, profits are split between the corporation and shareholders, which reduces each shareholder’s tax liability.
With S corporations, profits or losses are not taxed on a corporate return, but are taxed on the shareholders’ and owners’ personal tax returns. This avoids double taxation and allows the profits to be taxed at personal tax rates. This can be beneficial, but the more an individual shareholder makes, the higher the tax rate.
Choosing a business type has implications for how you file taxes and handle legal matters. Don’t be discouraged by paperwork and business-structure research. You can be on your way to becoming a business owner in no time.