A business can be organized in one of several ways, and the form its owners choose will affect the company's and owners' legal liability and income tax treatment. Here are the most common options and their major defining characteristics.
The default option is to be a sole proprietor. With this option there are fewer forms to file than with other business organizations. The business is structured in such a manner that legal documents are not required to determine how profit-sharing from business operations will be allocated.
This structure is acceptable if you are the business's sole owner and you do not need to distinguish the business from yourself. Being a sole proprietor does not preclude you from using a business name that is different from your own name, however. In a sole proprietorship all profits, losses, assets and liabilities are the direct and sole responsibility of the owner. Also, the sole proprietor will pay self-employment tax on his or her income.
Sole proprietorships are not ideal for high-risk businesses because they put your personal assets at risk. If you are taking on significant amounts of debt to start your business, if you've gotten into trouble with personal debt in the past or if your business involves an activity for which you might potentially be sued, then you should choose a legal structure that will better protect your personal assets. Nolo, a company whose educational books make legal information accessible to the average person, gives several examples of risky businesses, including businesses that involve child care, animal care, manufacturing or selling edible goods, repairing items of value, and providing alcohol. These are just a few examples. There are many other activities that can make your business high risk.
If the risks in your line of work are not very high, a good business insurance policy can provide protection and peace of mind while allowing you to remain a sole proprietor. One of the biggest advantages of a sole proprietorship is the ease with which business decisions can be made.
An LLC is a limited liability company. This business structure protects the owner's personal assets from financial liability and provides some protection against personal liability. There are situations where an LLC owner can still be held personally responsible, such as if he intentionally does something fraudulent, reckless or illegal, or if she fails to adequately separate the activities of the LLC from her personal affairs.
This structure is established under state law, so the rules governing LLCs vary depending on where your business is located. According to the IRS, most states do not allow banks, insurance companies or nonprofit organizations to be LLCs.
Because an LLC is a state structure, there are no special federal tax forms for LLCs. An LLC must elect to be taxed as an individual, partnership or corporation. You will need to file paperwork with the state if you want to adopt this business structure, and you will need to pay fees that usually range from $100 to $800. In some states, there is an additional annual fee for being an LLC.
You will also need to name your LLC and file some simple documents, called articles of organization, with your state. Depending on your state's laws and your business's needs, you may also need to create an LLC operating agreement that spells out each owner's percentage interest in the business, responsibilities and voting power, as well as how profits and losses will be shared and what happens if an owner wants to sell her interest in the business. You may also have to publish a notice in your local newspaper stating that you are forming an LLC.
Like the LLC, the corporate structure distinguishes the business entity from its owner and can reduce liability. However, it is considered more complicated to run a corporation because of tax, accounting, record keeping and paperwork requirements. Unless you want to have shareholders or your potential clients will only do business with a corporation, it may not be logical to establish your business as a corporation from the start - an LLC may be a better choice.
The steps for establishing a corporation are very similar to the steps for establishing an LLC. You will need to choose a business name, appoint directors, file articles of incorporation, pay filing fees and follow any other specific state/national requirements. (Find out how becoming a corporation can protect and further your finances. See Should You Incorporate Your Business?)
There are two types of corporations: C corporations (C corps) and S corporations (S corps). C corporations are considered separate tax-paying entities. C corps file their own income tax returns, and income earned remains in the corporation until it is paid as a salary or wages to the corporation's officers and employees. Corporate income is often taxed at lower rates than personal income, so you can save money on taxes by leaving money in the corporation.
If you're only making enough to get by, however, this won't help you because you'll need to pay almost all of the corporation's earnings to yourself. If the corporation has shareholders, corporate earnings become subject to double taxation in the sense that income earned by the corporation is taxed and dividends distributed to shareholders are also taxed. However, if you are a one-person corporation, you don't have to worry about double taxation.
S corporations are pass-through entities, meaning that their income, losses, deductions and credits pass through the company and become the direct responsibility of the company's shareholders. The shareholders report these items on their personal income tax returns, thus S corps avoid the income double taxation that is associated with C corps.
All shareholders must sign IRS form 2553 to make the business an S corp for tax purposes. The IRS also requires S corps to meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders, including individuals, certain trusts and estates
- Not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have one class of stock
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies and domestic international sales corporations)
General Partnerships, Limited Partnerships (LP) and Limited Liability Partnerships (LLP)
Goals Of Financial Management
A partnership is a structure appropriate to use if you are not going to be the sole owner of your new business.
In a general partnership, all partners are personally liable for business debts, any partner can be held totally responsible for the business and any partner can make decisions that affect the whole business.
In a limited partnership, one partner is responsible for decision-making and can be held personally liable for business debts. The other partner merely invests in the business. Although the general structure of limited partnerships can vary, each individual is liable only to the extent of their invested capital.
LLPs are most commonly used by professionals such as doctors and lawyers. The LLP structure protects each partner's personal assets and each partner from debts or liability incurred by the other partners. Different states have varying regulations regarding these establishments of which business owners must take note.
Partnerships must file information returns with the IRS, but they do not file separate tax returns. For tax purposes, the partnership's profits or losses pass through to its owners, so a partnership's income is taxed at the individual level. LPs and LLPs are also state entities and must file paperwork and pay fees similar to those involved in establishing an LLC.
Regardless of the way a business is structured, its owners will have the same overarching goals when it comes to the company's financial management.