As a business startup, one of the first decisions you need to make is the form of your business – whether or not to incorporate, become an LLC, a partnership, or just a sole proprietorship.
There are several ways to form a business. The most popular among small business owners is a sole propietorship. Also, partnerships, corporations, limited liability companies, limited liability partnerships, and “S” Corporations.
This tutorial teaches the basics of the different business entities and the advantages and disadvantages for choosing one type over another for your business. As with any major business or financial decision, please discuss this with your attorney and tax advisor before making a decision.
A sole proprietorship has many advantages for the small business owner. It’s controlled by you, all of the profits come to you, it’s easy to form, and you make all the decisions. With this type of entity, you have complete freedom over operating your business, whereas in most of the other business types you have to report to other people and share decision making.
You also have less government restrictions and control when you are a sole proprietorship, so you have a little less to report back to Uncle Sam.
Disadvantages for a sole proprietorship include unlimited liability. If your business is sued, you and your personal assets are at risk. As a sole proprietorship it may be more difficult raising capital, you may have to use your own money or personal loan for the business.
In today’s “stock option” world it may also be more difficult to find high caliber employees who want to own a portion of the company they are working for.
Another popular option for forming a business is a partnership. A partnership is an association of two or more people who share ownership and control over the business.
As with a sole proprietorship, a partnership is easy to form. You should create a legally binding partnership agreement between all of the partners, otherwise you may end up in disagreement about the amount of time and energy spent by each party in the business.
The partnership agreement should include how decisions are made, how the profits should be distributed, how disputes should be resolved, how new partners will be admitted, how existing partners can back out of the agreement, and what steps are necessary to dissolve the partnership.
The advantages for a partnership include its easy formation, profits flowing directly to the owners, benefit of more than one person working the business, and a better chance of raising capital from more than one person.
The disadvantages of a partnership include the liability of all of the partners in case of judgement against the business. Also, the partners are liable for the other partners’ actions. Profits of the business have to be shared with other people, disagreements could occur between partners, and the partnership may dissolve on death or withdrawal of one of the partners.
A corporation is a state-sanctioned entity that is a separate entity then those who own it. A corporation can be taxed, sued, and it can enter into contractual agreements. A corporation sells shares to its owners who elect a board of directors to oversee the company. A corporation does not dissolve when it changes ownership, it has a life of its own.
Generally, shareholders can not be held liable for a corporation or its debts, up to their investment in the company. A corporation’s officers can be held liable for their failure to perform an action, such as paying taxes. Corporations can raise money by selling stock. A corporation can also deduct the cost of benefits for its officers and employees.
Additionally, a corporation under certain circumstances can elect to become a S Corporation, with similiar taxation to a partnership. This election allows shareholders to treat earnings and profits as distributions and have them pass directly to their personal tax returns. The only catch is that if you are an employee, you have to pay yourself “reasonable compensation” for any work you perform for the company.
Disadvantages of a corporation include double taxation for some owners. A corporation is taxed at the corporate level and then again at the personal level for any dividends it pays out. The process to incorporate also takes a lot of paperwork and time, and in most states, money. This process is a lot more complicated than the other forms of business, and it is monitored much more closely by all levels of government.
Limited Liability Companies combine the advantages of corporations of limited liability with the control and tax advantages of a partnership. A Limited Liability Company is more complicated than a normal partnership in its formation.
The owners are the members and the life of the LLC is stated when the forms are filed. In general, the LLC is taxed as a partnership.
The advantages of an LLC is the limited liability of its controlling parties. If the LLC is sued, oftentimes the owners do not have their personal assets at risk. In a general partnership, the owners’ assets can be at risk if the company is sued.
The disadvantages include strict IRS rules as to when you can be taxed as an LLC and the rules you need to meet in different states to become an LLC.
Of course, in any important business decision, it is smart to talk to your tax attorney and lawyer before deciding on which form of business entity you need to become. There are many long term implications to choosing the right or wrong business type, so be sure to check with the professionals before making this important decision.