Most new businesses start out as sole proprietorships. This is the simplest form of ownership for a sole owner and requires little more than a tax ID number. However, when there are concerns over taxation or liability issues, or when the business has multiple owners, other organization types should be considered.
Which organization type is best for your business depends on a number of factors, including the type of business it is, the number of owners it has, and the degree of concern over taxation and liability issues.
- A sole proprietorship requires little more than a tax ID.
- A partnership is an agreement to share the business revenues. Each partner's share is taxed as personal income.
- A limited liability company is a partnership that shields each partner from personal liability for debts incurred by the business.
- The C corporation is a tax entity in and of itself and can lead to double taxation.
- An S corporation passes revenues directly to the partners, who report their shares as revenue.
A partnership is a straightforward business organization type to create. It requires an agreement that may be verbal or written.
In a partnership, the owners manage and control the business, and all revenue from it flows directly through the business to the partners, who are then taxed based on their portions of the income.
The partners are personally liable for all debts and any liabilities that result from the operation of the business.
The sole proprietorship and the partnership are the most straightforward business organization types.
When one partner leaves the business, it is dissolved unless there is an agreement in place that allows it to continue. A business continuation agreement typically stipulates the terms under which a partner can transfer a share of the business for some financial consideration.
The same agreement should provide for the transfer of a deceased partner's share so that the surviving family members receive fair compensation from the remaining partners.
Limited Liability Company (LLC)
The creation of a limited liability company (LLC) requires an operating agreement and a state filing of articles of organization.
Like the principals in a partnership, the owners of an LLC have direct management control over the company, and the company is required to file an information return to the IRS. The owners file their own individual returns based on the revenue that flows to them directly through the business. The information return shows how much revenue was paid to each partner.
The primary difference between a partnership and an LLC is that the latter is designed to separate the business assets of the company from the personal assets of the owners. That insulates the owners from personal responsibility for the debts and liabilities of the company.
In terms of the sale or transfer of the business, a business continuation agreement is needed to ensure the smooth transfer of interests when one of the owners leaves or dies.
C Corporation and S Corporation
There are two types of corporation, the S corporation and the C corporation. Both are legal entities that are formalized with the filing of articles of incorporation with the state.
The primary difference between the two is in their tax structures:
- The C corporation is a tax entity in and of itself, so it files a tax return and is taxed based on the revenues of the business. Double taxation could occur when the shareholders or owners file individual returns based on any income they receive in the form of dividends from the corporation.
- An S corporation is similar to a partnership and LLC in that it files an informational return. However, the revenue flows directly to the shareholder owners, who then file individual returns.
In most other aspects, the two business structures are the same. In both cases, the business is controlled by a board of directors which is answerable to the shareholders. The board hires the senior management team. Business assets and liabilities belong to the company, and the sale or transfer of interests can be achieved by the sale of shares.
Ultimately the type of business organization selected comes down to the owners' level of concern over management control, liability exposure, tax issues, and business transfer issues.
Because of the tax and legal implications involved, the guidance of a qualified tax attorney is essential in selecting the most suitable form of ownership.