Types of Business Entities
Today, there are several business entity options available for entrepreneurs. Like anything else, each of them has advantages and drawbacks.
A sole proprietorship is an unincorporated business entity that is owned by one person. It is very easy to create and operate. Since the business and the individual are identical, there is no paperwork to be filed with the government to form it or special maintenance required to keep the business alive. As long as you continue to call yourself a business, you are one.
Sole proprietorships cannot take advantage of special business income tax rates since all income is considered individual income. Sole proprietors are also not protected from personal liability if they end up in a legal dispute with a client or another person in the course of conducting their business. If a sole proprietor is sued, he is sued in his individual capacity. There are other entities such as a corporation or limited liability company that do offer an owner protection from liability.
General partnerships are formed by two or more persons who carry on a business for profit. Each of those persons is individually responsible for the partnership. This means that each partner is personally liable for the partnership’s debts and legal liabilities. In addition, each partner is jointly and severally liable for the acts of the other partner.
For tax purposes, all partners are considered self-employed and claim their share of the partnership’s income on their individual tax returns (the partnership itself pays no taxes). General partnerships are relatively easy and inexpensive to create and maintain. Although a partnership agreement is not legally required, it usually accompanies the formation of a general partnership. Partnership agreements generally cover topics like transferability, duration, and management control.
A limited partnership is very similar to a general partnership in structure. The main difference is that in a limited partnership, there are two different kinds of partners: general and limited. A limited partner does not take part in the management of the partnership and is not liable for any more than his individual capital investment. This type of entity is created to encourage investors to become limited partners and so they can share in the profits but not lose more than their own contribution. Limited partners must be careful not to participate in the control of the partnership or they may face loosing their status as limited partners.
Limited Liability Partnership
A limited liability partnership is a general partnership that files a registration with the secretary of state to operate as a limited liability partnership (LLP). Unlike the general partnership, all of the partners in a LLP enjoy protection from many of the partnership’s debts and liabilities. This provides a great advantage over the general partnership.
A “C” corporation is normally created through the state’s statutes for incorporation. It is a separate legal entity once it is formed. A corporation files its own taxes. A “C” corporation can have unlimited numbers of shareholders, and those shareholders can be any kind of legal entity.
Corporations require the most maintenance out of all other business entities. A board of directors must be elected, annual meetings must be held, minutes of corporate meetings must be kept, and stock must be issued. And all this applies even if you are the only shareholder in the corporation. If these formalities aren’t followed, you run the risk of losing your personal liability protection if a court decides that your corporation was just an alter ego of yourself created to keep you safe from law suits (this is sometimes referred to as “piercing the corporate veil”).
Additionally, corporations are said to be subject to “double” taxation, once at the corporate level and once at the shareholder level. You can avoid this drawback by not issuing dividends and simply re-invest your income back in the company. Spending your income on items that are tax-deductible is another way. You could also form an “S” corporation discussed below.
An “S” corporation is much like a “C” corporation in that it is also its own legal entity, protects its shareholders from legal liability, and requires more maintenance. However, an “S” corporation allows shareholders to claim their share of the corporation’s income directly on their personal tax return. This gets around the “double taxation” problem of a “C” corporation. The drawbacks of an “S” corporation are that they are limited to a maximum of 75 shareholders, each shareholder must be a US citizen or resident and there can only be one class of stock. However, if your intention is to keep your business relatively small, this is an excellent option.
Limited Liability Company
A limited liability company (LLC) is for the most part a combination between a corporation and a partnership. An LLC provides the same kind of tax and liability benefits as a corporation, but has the same management structure as a partnership. An LLC has members instead of partners. A member enjoys the protections from the liabilities and the debts of the LLC. An LLC comes into existence when the Articles of Organization are submitted to the state. The LLC members should create an Operating Agreement to govern themselves by.
Regardless of the entity you choose, the steps to forming it are essentially the same:
- Decide which state you want to form your company in. You’ll need to either be physically present in the state you choose, or hire a registered agent who is.
- Choose a name for your company. You’ll need to pick something that isn’t already taken in the state you have chosen.
- Follow the instructions for your state to form your company.