Once you decide to start your own business, next you must decide how to structure your small business. The structure of your small business determines your personal liability for losses and the taxes you will pay, so choosing the right business structure is essential. Here is a brief description of the business structures available to your small business.
(The One-man Show!)
A sole proprietorship is a small business owned by one person, the sole proprietor. No paperwork or legal formalities are necessary to create a sole proprietorship. The sole proprietor personally pays all taxes on earnings and profits generated by the company. However, the sole proprietor is liable for all the business’ losses.
A general partnership is a business owned by two or more people. A general partnership requires an agreement between the “partners” to carry on as co-owners of a business for profit. A partnership is created by as little as a handshake or through more formal documents, such as a partnership agreement, often drafted by a lawyer. Partners equally share all profits and losses unless otherwise agreed to in a partnership agreement.
- Tax benefits: Profits generated by general partnerships are only taxed at the personal income level of its owners. There is no company-level taxation. Other business structures, such as a C-corporation, are double-taxed at the business entity and personal income levels.
Limited partnerships are created by “partners” under their state’s limited partnership law. These entities require at least one “general partner” and at least one “limited partner.” General partners have the advantage of benefiting from a preferred tax status, but have unlimited personal liability for all activities conducted by the partnership. Limited Partners are passive investors with no rights or fiduciary duties; however, they have absolutely no personal liability and only stand to lose their personal investment if the partnership fails.
- Main advantage: No personal liability for silent investors. Limited partners may not participate in managing the business, but enjoy earnings and profits without risk to their other assets.
Limited Liability Company
LLCs are one of the most popular entity forms among small business owners, combining the best features of corporations and partnerships. LLCs are formed by filing articles of organization with the Secretary of State, which allows the owners to enjoy protections reserved for corporations and tax treatment reserved for partnerships. In turn, LLCs limit personal liability for every member, similar to corporate shareholders, yet taxes pass-through to the personal level, avoiding double corporate taxation.
- LLCs are the most flexible business entity. They enjoy limited liability, in which owners are not personally liable for the debts and losses of the business.
- LLCs enjoy flow-through income taxation, like a partnership, meaning profits and losses flow through to company owners who are only taxed on the personal income level. LLCs are NOT double-taxed on the entity level and the personal income level like most corporations.
- Company names must include the term LLC to enjoy tax preference.
A corporation (known as a C corp) is an independent business entity which exists separate from its owners. The law treats corporations as a separate legal entity based on statute, referred to as a “Corp.” or “Inc.” This business structure allows shareholders, the owners, the flexibility to sell their ownership stake while protecting the life of the company. Corporate structure is great for expanding businesses that foresee adding or subtracting shareholders.
- Limited liability is also a touchstone of corporate structure, limiting the shareholder’s financial liability to their financial investment.
- Corporations are double-taxed. The company is taxed as a business entity, and its shareholders’ personal income received from corporate earnings and profits is taxed.
The S corporation provides both limited liability and flow-through tax benefits to corporations that qualify as “Small Business Corporations” under the IRS’ tax code. There may not be more than 100 shareholders to qualify as an S corp. The qualifications under the tax code greatly limit the size and range of use for S corporations. However, S corps are often a preferred small business option due to limited personal liability for shareholders and flow-through taxation, which wholly eliminates the double corporate tax.
Choosing a Structure for Your Business
Be sure to choose the business structure that provides the most benefits to meet your needs. Qualified business law attorneys often help entrepreneurs set up and register their small business.
States generally require limited partnerships, LLCs, and corporations to register with the Secretary of State of the business’ home state, or the appropriate state office. Be sure to check out your state government’s website for more information.