A key issue to consider when starting a business is selecting the type of business entity to form. There are several common business entities, and each one has distinct features, as well as advantages and disadvantages. These primarily concern how income from the business structure is taxed, and whether the owners of the business entity can be held personally liable for wrongdoing. Plus, the type of business structure determines the income tax return form that must be filed with the state department of revenue (if applicable) and the IRS.
Common Forms of Businesses
The most common forms of businesses are the sole proprietorship, partnership, the corporation, and the Limited Liability Company or “LLC.”. Let’s examine each of these (and a couple more!):
Sole Proprietorship. A sole proprietorship is defined as a just a sole person or a married couple in business alone. This is the “Mom & Pop” convenience store on the corner, and it’s the most common type of business structure in the United States. A big benefit of a sole proprietorship is that it’s quite easy to set up and operate. A sole proprietorship also allows for more management flexibility, fewer legal restrictions, and less tax requirements.
On the down side, the business owner is personally liable for all debts incurred by the business. That’s because sole proprietorships don’t really create a separate business entity. As a result, your business assets and liabilities are the sole proprietorship’s assets and liabilities. In addition to having no protection from personal liability in this type of business organization, other negatives include the fact that it can be difficult to raise money because you aren’t allowed to sell stock, and banks are reluctant to lend to sole proprietorships.
Even so, a sole proprietorship may be a good option for low-risk businesses and entrepreneurs who’d like to try out their business idea before creating a more formal business.
Corporation. As you might expect, a corporation is one of the most complex business structures. A corporation—also known as a “C Corp”—is a legal entity that’s entirely separate from the business owners. A corporation has certain rights, privileges, and liabilities, and doing business as a corporation may provide significant tax or financial benefits. Corporations provide the greatest protection to business owners from personal liability. Corporation owners can also have an easier time raising funds because they can do so with the sale of stock—which also an enticing benefit in attracting quality employees.
However, the negatives include increased expense in forming a corporation, as well as considerable legal requirements for record-keeping, operations, and reporting to the state. There’s also less personal control and other regulatory compliance that must be considered when thinking about forming a corporation. These include electing a board of directors, holding annual meetings, and producing annual reports.
Partnership. A General Partnership is composed of two or more individuals who’ve agreed to contribute financial backing, labor, or expertise to a business. Each partner shares the profits, losses, and management of the business, but each is also personally and equally liable for the partnership debts. The formal partnership terms are usually set out in a written partnership agreement.
In contrast, a Limited Partnership is made up of one or more general partners and one or more limited partners. The general partners manage the business and are entitled to share fully in the organization’s profits and losses. And while the limited partners also share in the profits of the business, their losses are limited to the level of their financial investment. The limited partners typically don’t get involved in the day-to-day operations of the business. On the plus side, partnerships are fairly easy to form, but may need to register with the Secretary of State’s Office, depending on state law.
Limited Liability Company (LLC). A Limited Liability Company or “LLC” is a business structure that’s specifically permitted by state statute. An LLC is created by one or more individuals or entities through a special written agreement. In fact, one LLC can even by owned by another LLC: it’s not unusual for a business owners with several business interests to form a parent LLC and subsidiaries which can help with organization and minimize risk.
An LLC agreement will include provisions regarding the organization of the LLC—a description of management, the assignability of interests, and the way in which LLC profits and losses will be distributed. LLCs are generally allowed to engage in any lawful, for-profit business or activity, with some exceptions (like banking or insurance). Depending on how the LLC is structured, there’s no federal tax at the entity level, and income and loss are passed through to LLC’s members (owners).
Again, state law controls how LLCs operate, so the upside and downside differs on where the LLC is formed and registered. In some states, LLCs can have a limited life. In addition, when a member joins or leaves an LLC, some states require the LLC to be dissolved and re-formed with new membership, provided there’s no contingency for this in an agreement within the LLC for purchasing, selling, or transferring ownership.
The LLC must be registered with the Secretary of State, and there are some other formal requirements, but these are less formal than corporations.
In addition to the LLC, there are two similar structures: the Limited Liability Limited Partnerships (LLLP) and the Limited Liability Partnerships (LLP). A LLLP is a Limited Partnership that elected to become an LLLP by including a statement to that effect in its certificate of limited partnership. This type of business structure may protect its general partners from liability for obligations of the LLLP. An LLP is like a General Partnership except that typically a partner isn’t personally liability for the negligence of another partner. This business structure is frequently adopted by professionals, such as accounting and law firms. Both LLLPs and LLPs must also file paperwork with the Secretary of State.
When determining the right type of business organization for your company, remember to look at the legal and tax protections and implications. These factors will help you gauge your level of acceptable personal risk and liability, your financial commitment, and the amount of paperwork that will be required by the state to form and operate your business.