Setting up a business structure is one of the first things small businesses owners need to think about when starting a business. There are several options to choose from, like a sole proprietorship, partnership, limited liability company, or a corporation. You need to select the business structure that is attainable with your current resources and will best meet your objectives. Not every structure will be right for you, and each has its own strengths and weaknesses, as well as tax implications. To help you make your decision, here are some basic facts about five major types of business structure, their systems of ownership and their tax implications.
This category is the most common for small businesses, because it is easy to set up due to its simple and informal structure. One person owns all the assets and profits of the business, but also owns all the responsibility of its liability and debt. Legally, the owner and the business are one and the same. The owner can also report losses and profits on his or her personal income tax return.
A Partnership is similar to a "sole proprietorship," except that two or more people share ownership of a business, as well its assets, profits, liability and debt. Again, the business and its owners are indistinguishable in eyes of the law. A Partnership agreement allows the partners to split profits and liabilities as long as they have a substantial economic effect. Partnerships are not required to pay taxes. Instead, they file informational returns, and each partner reports their share of profits and losses. There are different types of partnership agreements as well:
- A general partnership assumes equal shares between the partners unless the written agreement states otherwise.
- A limited partnership limits both the owners’ liability and the owners’ ability to make management decisions.
- A joint venture is like a general partnership, but only lasts for a limited period of time or single project.
A Corporation is a unique entity under the law: it is separate from the identity of its owners, and is treated as a person, as it can be taxed, sued, and can enter contracted agreements. Shareholders (i.e., owners) have limited liability for debts and judgments, but officers can be held responsible for their own actions. While corporations do have some special rights (e.g., they can earn funding through stocks), they are also more costly to set up, they are more heavily monitored and regulated, and they pay more taxes. Corporations have a complex structure and are costly to start up, so they require the help of a qualified attorney.
Corporations can opt for this tax policy, which allows a shareholder to treat profits or earnings as distributions and pass them directly to a personal tax return. If the shareholder works for the company and earns a profit, however, he or she must pay his or her own wages. Basically, the Subchapter S helps corporations avoid double taxation. This form is similar to a Partnership in that the corporation is not taxed and all income and losses pass through directly to its shareholders.
Limited Liability Company
An LLC is a hybrid business structure and is permitted in all states. It is structured to offer the limited liability of a corporation with a partnership’s tax efficiency and flexibility of operations. The duration of a Limited Liability Company is usually established up front, but can always be extended. The so-called "check the box" regulations allow a business entity with two or more owners to elect to be classified as either a Partnership or a Corporation. Those electing Partnership status can then organize as an LLC under state law.