Once you have decided to start a business then the question becomes: How do you do it? There are a lot of choices to make when starting a business. One of the first choices to make is choosing the type of business entity you will form. Some of the factors to consider are liability protection, ease of management, and taxes. Here is a simple guide to the most common types business entities that can be used, and a very quick rundown of the characteristics and some advantages/disadvantages of each:
Sole Proprietorship: If you do any work for compensation outside of your normal, W-2 wages you probably are probably already operating a sole proprietorship. A sole proprietorship is the simplest form of business because it is just you doing business as yourself. All of the profits of the business are attributed personally to the proprietor. However, a sole proprietor has what is known as “unlimited liability”; that is, the sole proprietor is completely liable for the debts and liabilities of the business. This is true even in the event of a lawsuit or similar disaster where all of the owner’s assets are subject to the judgment or recourse involving the business. In general, a sole proprietorship is very simple to set up and run, but can be very risky. In addition, taxation as a sole proprietorship can be more difficult to manage. Keeping separate records for personal versus business expenses can sometimes lead to the loss of certain tax advantages.
Partnerships: Working in partnership with others who you trust is a great idea and can maximize your skills. Partnerships are two or more people who work together for a common aim or goal. Management in a partnership is usually based on consent between the parters and taxes are paid by the individuals on their respective share of the profits. Like a sole proprietorship, general partnerships can be formed almost without trying simply by working together with someone. Unfortunately, general partnerships contain all of the risks as a sole proprietorship, but those risks are doubled because you have another person doing in your name. As a result, you can be held liable not only for your debts and liabilities but for your partner’s as well. Accordingly, general partnerships are almost never advised. However, there are some forms of partnership that do limit liability such as a limited liability partnership or a limited partnership. These special entity partnerships are useful for some business models. Limited liability partnerships are a legal entity that usually involve 2 or more individuals, each of whom is active in operating the company. Limited partnerships are a legal entity usually involve 1 partner who is referred to as the “general partner” who operates the company and 1 or more “limited partners” who are passive investors in the company. Your legal advisor can help determine if either of these entities are right for you.
Corporation: This is probably the most common form of business, and probably the one that is generally most familiar to prospective business owners. All publicly traded companies (e.g. Exxon, Amazon, Apple) are corporations. Corporations issue stock, have shareholders, CEOs, and put “Inc.” behind their name. All of these sound like activities of a multi-national conglomerate, but in reality, a corporation can be any size. People recognize and understand the corporate form. Unlike sole proprietorships or general partnerships, corporations have limited liability for their owners, that is, the individual owners are typically not personally liable for the company’s debts and liabilities. A corporation is seen as a separate legal entity from the owners. In addition, for those dreaming big and hoping to one day become a publicly traded company, a corporation is the best entity because stock is the easiest type of ownership to transfer. However, there are several disadvantages of the corporate form. Corporations require a decent amount of internal management, reports, resolutions, and separate tax returns. Speaking of taxes, traditional corporations are subject to a form of double taxation. When the corporation has income the corporation is taxed first; then that income is passed on to shareholders in the form of dividends where it is taxed again. Double taxation can be mitigated in some cases by electing to be taxed as a Subchapter S corporation. Talk to your legal advisor to determine if this is an option for you.
Limited Liability Corporation (LLC): The LLC is a relatively new type of entity and the one that I recommend to clients most often. An LLC combines the best aspects of sole proprietorships/partnerships, ease of use and flow through taxation, with the best aspect of corporations, limited liability. The hallmark of an LLC is flexibility. You can choose the management style, the way it is taxed, the way decisions are made, and even the way the owners are paid. If there is only one owner, or if the owners are married, you don’t even have to file a separate tax return and can instead pass everything through to the owner’s tax return. In many states the only administrative burden is a yearly report and fee. LLCs avoid the double taxation of corporations, but still give the liability protection of being a separate entity. For the vast majority of people starting businesses, this form hits the sweet spot.
For more information on how to get started forming an entity, contact The Stanfield Firm: