When starting a business of any size, it is important to determine which legal business structure is best. For small businesses, especially a home-based business, this step may be considered unnecessary or simply may be overlooked. The type of entity chosen, however, has very specific tax consequences and legal ramifications. Do not leave this decision to chance. Research the options available and choose the entity that best fits the type of business and the parties involved.
Sole Proprietor – A Simple Form of Business Ownership
A sole proprietorship is a very common, very simple form of business. Although usually operated by an individual, a married couple may also conduct business as a sole proprietor. For tax and liability purposes, a sole proprietorship is legally inseparable from the owner. This form has many advantages in that it is easy and inexpensive to set up and federal income taxes are simple to report on a Schedule C form.
The disadvantages to operating as a sole proprietor stem from the primary advantages. Due to the simplicity of the structure, a sole proprietorship offers no protection to the owner from taxes or liability. All of a sole proprietor’s personal assets, not just the assets of the business, are potentially at risk should creditors come calling.
General Partnership – A Simple Business Structure for Multiple Owners
When two or more people elect to conduct business together, a general partnership is a relatively easy form of business to set up. Forming a partnership, especially when only two individuals are involved, is often done through a verbal agreement but it is important to create a valid, written partnership agreement as soon as possible.
A partnership agreement should include how ownership is shared, the time commitment and financial investment expected from each partner, how decisions will be made and disputes resolved, how profits will be divided, and how new partners may enter or existing partners may exit. It should also clearly state what action will be taken in the event of death or disability of a partner and provide for other contingencies, such as dissolution, as well.
As with a sole proprietorship, all personal assets of the partners involved in a general partnership are potentially at risk to satisfy taxes or other liabilities. When considering a partnership, bear in mind that each partner is liable for the actions of all the partners. For federal income tax reporting purposes, the partnership files an informational return and the income allocated to each partner is then included on each partner’s tax return.
Other forms of partnership that are not covered here include a Limited Partnership, where liability is limited to the extent of the partner’s investment, and a Joint Venture, where the partnership is formed for a specific time period or project only. Both of these business entities are more complex to form than a General Partnership and require adherence to certain formalities.
Corporation – A Separate Business Entity
Held by shareholders and run by a board of directors, a corporation is a separate legal entity chartered by a state. Set up as a nonprofit or for profit venture, a C Corporation is complex and expensive compared to other business forms but generally shields shareholders from liability. C Corporations are stringently regulated and taxes are paid on profits by the corporation and then again when distributed to shareholders.
An S Corporation provides the asset protection advantages of a C Corporation but is taxed in the same way as a partnership. Taxes on profits are paid by the shareholders only; the corporation itself pays no tax separately. As with a C Corporation, an S Corporation is owned by shareholders, run by a board of directors and subject to regulation.
Limited Liability Company (LLC) – A Flexible Business Structure
Combining the protection from liability advantages of a corporation with the tax advantages of a sole proprietorship or partnership, a Limited Liability Company (LLC) provides a flexibility that may be especially attractive to small business. Rather than stockholders, the owners of an LLC are members who manage the company or appoint others to do so. In addition, an LLC may choose to be taxed like a corporation but will still not be bound by corporate formalities.
Choose Your Business Structure Wisely
When starting a business, it is important to choose the structure carefully. Each type of entity comes with a specific set of restrictions, as well as legal and tax ramifications. While a sole proprietorship can often be set up without assistance, it is usually best to consult an attorney when creating a partnership agreement or contemplating a corporation or LLC. Thoroughly discuss the pros and cons of each possibility before choosing a structure for any business.
There are a variety of online resources to assist any budding entrepreneur. For more information on starting a small business, start with the Small Business Administration. For tax specific information, get answers straight from the IRS website.