Business Entities: A Brief Overview
When you are first starting a business there is a laundry list of things to consider: 1) what you are going to do, 2) how you are going to run the business, 3) how you are going to make profits, 4) who are your competitors, 5) what marketing strategy to use, etc. One of the significant issues that may look seemingly unimportant is choosing the structure of the business. According to the IRS, there are five main types: sole proprietorship, partnership, corporation, LLC, and S corporation. Which type to choose depends on many different things, including the nature of the business, what tax incentives you are looking for, and how much liability you want? We have compiled from various resources (listed below) helpful pieces of knowledge that we believe could be of assistance.
If you want to keep it simple and are running the business by yourself, then a sole proprietorship may be the structure for you. This type of business is basically a one person business, since the owner is not legally separate from the business. Even though this is a one person business, typically the business has a DBA name (doing business as), allowing you to operate without your legal name.
Not only does it make accounting and tax returns simple, but this type has the least amount of government regulations, allowing such freedoms like keeping all the profits made and not having to do much paperwork when forming or terminating the business. As the only owner you call all the shots, making decision-making quicker and allowing you to have more control of business.
However, since the business is not legally separate from you, you are personally responsible for all debts and all lawsuits. Also, due to the lack of government regulations and the simple structure of this type of business, many banks look down to it, making it hard to get loans. It is also not allowed to distribute shares of the business, which makes raising capital hard to do.
In a partnership, two or more people own the business, so they share the profits and losses of the business. Also, all partnership entities do not enjoy perpetual lifetimes; once the owners decide to quit the business or die, the business entity goes along with them. There are three main types: a general partnership, a limited partnership, and a limited liability partnership.
A general partnership is similar to a sole proprietorship, only it is with two or more people. It is recommended for some sort of an agreement to be made between the owners, just in case a dispute arises, but it is not required by law.
Some advantages include: being free to manage the business directly, less filings and paperwork, and simpler accounting.
The disadvantages of a general partnership are that partners are liable not only for business debts and lawsuits that come up, but also for the actions of the other partners. It is similar to the situation when you are an apartment renter and have one or two roommates. Both you and your roommate are responsible for the apartment, and if she/he decides to “forget” to pay their half of the rent for the month, the landlord is still expecting the full rent, so you may have to pay their share as well.
In this type of partnership, some of the partners are considered limited partners and some are considered general partners. The general partners have the same amount of liability as they would if they were in a general partnership, but limited partners are only liable equal to the amount they put into the business.
An advantage to this is that the limited partners are not liable for every debt and every lawsuit.
The main disadvantage is that it may be complicated, more costly, and limited partners are not allowed to be active in the day to day operation of the business.
Most commonly seen amongst professional businesses such as doctors, lawyers, and accountants, this type of partnership has no general partner; all of the people involved are limited partners.
This allows all partners to enjoy both advantages of a partnership and a corporation; they are allowed to directly manage the business, and they have limited liability, so the losses will never surpass whatever amount they invested and they are not liable for the actions of the other partners. Another advantage is that it avoids double taxation, with pass through taxation. The taxes for the profits are not taxed at the company’s tax returns (there is only an informational return filed); it only shows up on the individual tax returns of the partners.
Some disadvantages are that there is additional paperwork, increased fees, and there are stricter insurance requirements. Also, since the partners and the company usually are involved in professional licenses, lawsuits filed usually are not only are filed against the company, but also against anyone who is involved in it in a malpractice type suit.
What sets a corporation away from the other business structures is that the business functions separately from the owners. The owners are shareholders; they buy a share of the business, which both contributes capital to the business and allows owners to have some control over the business.
This arrangement allows some key benefits: 1) the business doesn’t have to end once the owners decide quit the business, 2) the business has its own legal standing, so it can sue and be sued, and also hold property in its own name, and 3) limited liability, so owners will never be asked to pay for losses that are greater than the amount they invested.
Corporations operate at a higher cost when compared to the other business structures due to the “double taxation structure” where they are taxed on a corporate level and then any money distributed is taxed on individual level. Additionally, they have more filing fees, and other state fees. Also, since corporations are more closely watched by the government (read: Antitrust laws), there are all sorts of mandatory formalities set in place, such as the mounds of paperwork required for registration and recording board meetings minutes.
An S corporation is a type of corporation that was made to help mainly small businesses; all the liabilities of a corporation are similar, but unlike a regular corporation, s corporations aren’t doubly taxed; the company is taxed for wages only, not on dividends. The taxes for the distributed dividends are given to the shareholders instead.
Since this type is still considered corporations, the same benefits that apply to a regular corporation are shared with an S corporation. However, as mentioned above, this type of corporation avoids double taxation.
There are just as much rules, regulations, and paperwork to file as a c corporation. On top of that, there are certain qualifications that companies have to have in order to be able to be an s corporation. There is a limit to the number of shareholders they have (less than 100), there must be only one type of stock distributed, the corporation must be incorporated only in the US, and all shareholders must be either US citizens or residents.
This structure is a hybrid structure combining both a corporation and a partnership. Like a partnership, the profits and losses are passed through to the owners, and like a corporation, the owners enjoy limited liability.
A LLC enjoys most of the same benefits as a corporation: limited liability, perpetual lifetime, and its own legal status. On top of that, a LLC does not have as many formalities as a corporation does; they do not have to file as many papers or hold board meetings. They are given more freedom in how to run the company, allowing the owners to run the company instead of electing officers to do it for them. Also, when compared to an S corporation, an LLC does not restrict the number of owners allowed.
The LLC structure is relatively new compared to the other structures, and some creditors may feel uneasy giving these companies credit due to the lack of judicial review or scrutiny in this area of law (though the structure is very commonplace today). There are also restrictions to which kind of businesses can file to be an LLC. Banks, insurance companies, and nonprofit organizations are not allowed to become a LLC. Another drawback is the amount of taxes paid. The owners are taxed for the company’s net income, with the self employment rate (15.3%); this rate includes the taxes for Social Security and Medicare.
When picking a business structure, remember that you can always change the structure of your business to fit you needs. If you are just starting out, it may be wiser to start out with the simpler structure of business rather than jumping in to the formal structure of a C corporation. You should mainly consider what your present needs are and fulfill them first, then as time goes by and your business starting picking up, you can adjust accordingly. Remember to always talk to your tax and legal advisors to make sure that you are fully aware of the issues that could confront you.
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Disclaimer:
The information on this page is not to be taken in place of the advice of a tax specialist or of an attorney. Please consult a licensed attorney and/or qualified tax specialist for help making decisions involving your business.