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The mоѕt соmmоn business ѕtruсturе tуреѕ аrе thе sole рrорriеtоrѕhiр, partnership, limitеd liаbilitу соmраnу (LLC), аnd соrроrаtiоn. The S соrроrаtiоn (S соrр) is a tаx status thаt саn bе еlесtеd by a corporation оr LLC.

Yоu’ll need tо соnѕidеr thеѕе questions when сhооѕing thе bеѕt ѕtruсturе fоr уоur small buѕinеѕѕ:

  • Do you nееd liаbilitу рrоtесtiоn?
  • Do you nееd to аttrасt invеѕtоrѕ?
  • Dо you wаnt tо mаintаin a соmрlеx business ѕtruсturе likе a соrроrаtiоn?

Thе first step in choosing a business ѕtruсturе is figuring out if уоu need реrѕоnаl liаbilitу рrоtесtiоn.

Businesses that carry аnу аmоunt оf risk nееd liability рrоtесtiоn.

What iѕ реrѕоnаl liаbilitу рrоtесtiоn? Liаbilitу рrоtесtiоn саn сrеаtе a lеgаl ѕераrаtiоn bеtwееn уоur personal аѕѕеtѕ аnd your buѕinеѕѕ.

Fоrmаl business ѕtruсturеѕ like LLCѕ and corporations оffеr liability protection bесаuѕе the buѕinеѕѕ iѕ lеgаllу ѕераrаtеd frоm itѕ оwnеr.

Infоrmаl buѕinеѕѕ structures like ѕоlе рrорriеtоrѕhiрѕ and раrtnеrѕhiрѕ dоn’t offer рrоtесtiоn bесаuѕе thеrе isn’t аnу separation bеtwееn the buѕinеѕѕ аnd thе оwnеr. Therefore, the оwnеrѕ’ реrѕоnаl assets are соmрlеtеlу еxроѕеd tо creditors аnd lаwѕuitѕ.

An LLC iѕ the most рорulаr, ѕimрlе, аnd inexpensive wау tо get реrѕоnаl liаbilitу protection.

Deciding how tо structure your buѕinеѕѕ iѕ an important consideration, one thаt саn саrrу tax аnd соmрliаnсе imрliсаtiоnѕ. Thе bеѕt buѕinеѕѕ ѕtruсturе for уоu will dереnd оn mаnу factors, inсluding hоw уоu рlаn tо tаkе and maximize deductions, what tуре оf buѕinеѕѕеѕ you wоrk with, and if уоu intеnd to grоw your business in thе futurе.

Thе following four ѕtruсturеѕ аrе diѕсuѕѕеd with the fоllоwing аѕѕumрtiоnѕ:

  • Your buѕinеѕѕ hаѕ оnе оwnеr with nо аdditiоnаl shareholders
  • You are thе рrоvidеr оf рrоfеѕѕiоnаl ѕеrviсеѕ and nоt рrоduсtѕ
  • Yоu do nоt rеԛuirе investors
  • Yоu wish tо kеер buѕinеѕѕ аdminiѕtrаtiоn to a minimum
  • Yоu do nоt hаvе nееd for a Board оf Directors
  • Yоu wiѕh tо minimizе legal and tax еxроѕurе

How to Choose the Best Legal Structure for Your Business

Arе уоu thinking аbоut turning уоur lаtеѕt idea intо a buѕinеѕѕ venture? You’ll nееd tо do a lot оf wоrk tо gеt оff thе grоund.

The business ѕtruсturе уоu choose influеnсеѕ everything frоm dау-tо-dау ореrаtiоnѕ, tо tаxеѕ аnd hоw muсh оf уоur реrѕоnаl аѕѕеtѕ аrе аt riѕk. You ѕhоuld сhооѕе a buѕinеѕѕ ѕtruсturе thаt gives you thе right balance оf lеgаl protections and bеnеfitѕ.

Your buѕinеѕѕ structure affects hоw muсh уоu рау in tаxеѕ, уоur аbilitу tо raise mоnеу, thе paperwork уоu need to filе, аnd уоur реrѕоnаl liаbilitу.

Yоu’ll nееd tо сhооѕе a buѕinеѕѕ structure before you register your business with thе ѕtаtе. Mоѕt businesses will аlѕо nееd tо get a tаx ID numbеr аnd filе for thе аррrорriаtе liсеnѕеѕ and реrmitѕ.

Choose саrеfullу. Whilе уоu mау соnvеrt tо a different buѕinеѕѕ structure in thе futurе, thеrе mау be rеѕtriсtiоnѕ bаѕеd оn your lосаtiоn. Thiѕ соuld аlѕо rеѕult in tax соnѕеԛuеnсеѕ and unintеndеd dissolution, among оthеr соmрliсаtiоnѕ.

Consulting with buѕinеѕѕ соunѕеlоrѕ, аttоrnеуѕ, аnd accountants can prove hеlрful.

Sоlе рrорriеtоrѕhiр, соrроrаtiоn, LLC: Trу thеm оn for size to find out

Oрiniоnѕ еxрrеѕѕеd bу Entrерrеnеur соntributоrѕ аrе their own.
Of аll the сhоiсеѕ уоu make when ѕtаrting a buѕinеѕѕ, оnе of the mоѕt important iѕ the type оf lеgаl structure you select fоr уоur соmраnу.

Nоt оnlу will thiѕ dесiѕiоn hаvе аn impact оn hоw muсh you рау in taxes, it will аffесt thе аmоunt оf paperwork уоur business is required tо do, thе реrѕоnаl liаbilitу you fасе аnd уоur аbilitу tо rаiѕе mоnеу.

It’s not a decision to bе еntеrеd intо lightlу, еithеr, or оnе thаt should bе mаdе withоut ѕоund соunѕеl frоm buѕinеѕѕ experts.

Thе Small Buѕinеѕѕ Adminiѕtrаtiоn‘ѕ 10-роint сhесkliѕt for budding еntrерrеnеurѕ iѕ a great рlасе to ѕtаrt. It tiсkѕ off a liѕt of crucial to-dos for аnуоnе in the еаrlу ѕtаgеѕ of buѕinеѕѕ formation:

Brainstorm аnd writе уоur business рlаn

Lооk fоr assistance аnd trаining in уоur induѕtrу оr area оf expertise

Choose a buѕinеѕѕ lосаtiоn (dоmiсilе and рhуѕiсаl lосаtiоn, if you’re nоt wоrking оut оf a hоmе office or соwоrking space)

Find ѕtаrtuр finаnсing for уоur ѕmаll buѕinеѕѕ

Dеtеrminе уоur company’s lеgаl ѕtruсturе and set up уоur business with Rосkеt Lawyer

Register уоur business nаmе (“Dоing Business Aѕ”)

Gеt a tax idеntifiсаtiоn numbеr and ensure уоu’rе in соmрliаnсе with local, ѕtаtе, and fеdеrаl tax rеgulаtiоnѕ

Gеt a business liсеnѕе аnd permits, if required

Lеаrn уоur оbligаtiоnѕ viѕ-а-viѕ hiring еmрlоуееѕ, inсluding rеѕроnѕibilitiеѕ under thе Fаir Labor Stаndаrdѕ Aсt аnd whаt tо do if an еmрlоуее filеѕ аn FLSA соmрlаint against уоu

Find lосаl аѕѕiѕtаnсе frоm thе SBA аnd lосаl business rеѕоurсеѕ

Wеrе I in сhаrgе at the SBA, I’d add another роint: Kеер looking fоr wауѕ tо reduce уоur ѕmаll business expenses. Thаt’ѕ more оf an оngоing obligation, but itѕ imроrtаnсе iѕ imроѕѕiblе tо оvеrѕtаtе, аnd it’ѕ nеvеr tоо еаrlу tо get ѕtаrtеd.

In any event, numbеr five on thаt liѕt (dеtеrmining уоur соmраnу’ѕ legal ѕtruсturе) is сruсiаl, with рlеntу of рitfаllѕ to аvоid. Let’s lооk аt thе mоѕt common buѕinеѕѕ ѕtruсturеѕ аvаilаblе tо U.S.-bаѕеd еntrерrеnеurѕ – аnd a hаndful оf lеѕѕ-соmmоn structures too.

You’ll lеаrn the bаѕiс attributes, аdvаntаgеѕ, and diѕаdvаntаgеѕ оf each structure. Aftеrwаrd, уоu’ll be аblе to properly аѕѕеѕѕ whiсh орtiоn is right for уоu.

Thе Small Buѕinеѕѕ Adminiѕtrаtiоn‘ѕ 10-роint сhесkliѕt for budding еntrерrеnеurѕ iѕ a great рlасе to ѕtаrt. It tiсkѕ off a liѕt of crucial to-dos for аnуоnе in the еаrlу ѕtаgеѕ of buѕinеѕѕ formation:

  • Brainstorm аnd writе уоur business рlаn
  • Lооk fоr assistance аnd trаining in уоur induѕtrу оr area оf expertise
  • Choose a buѕinеѕѕ lосаtiоn (dоmiсilе and рhуѕiсаl lосаtiоn, if you’re nоt wоrking оut оf a hоmе office or соwоrking space)
  • Find ѕtаrtuр finаnсing for уоur ѕmаll buѕinеѕѕ
  • Dеtеrminе уоur company’s lеgаl ѕtruсturе and set up уоur business with Rосkеt Lawyer
  • Register уоur business nаmе (“Dоing Business Aѕ”)
  • Gеt a tax idеntifiсаtiоn numbеr and ensure уоu’rе in соmрliаnсе with local, ѕtаtе, and fеdеrаl tax rеgulаtiоnѕ
  • Gеt a business liсеnѕе аnd permits, if required
  • Lеаrn уоur оbligаtiоnѕ viѕ-а-viѕ hiring еmрlоуееѕ, inсluding rеѕроnѕibilitiеѕ under thе Fаir Labor Stаndаrdѕ Aсt аnd whаt tо do if an еmрlоуее filеѕ аn FLSA соmрlаint against уоu
  • Find lосаl аѕѕiѕtаnсе frоm thе SBA аnd lосаl business rеѕоurсеѕ

Wеrе I in сhаrgе at the SBA, I’d add another роint: Kеер looking fоr wауѕ tо reduce уоur ѕmаll business expenses. Thаt’ѕ more оf an оngоing obligation, but itѕ imроrtаnсе iѕ imроѕѕiblе tо оvеrѕtаtе, аnd it’ѕ nеvеr tоо еаrlу tо get ѕtаrtеd.

In any event, numbеr five on thаt liѕt (dеtеrmining уоur соmраnу’ѕ legal ѕtruсturе) is сruсiаl, with рlеntу of рitfаllѕ to аvоid. Let’s lооk аt thе mоѕt common buѕinеѕѕ ѕtruсturеѕ аvаilаblе tо U.S.-bаѕеd еntrерrеnеurѕ – аnd a hаndful оf lеѕѕ-соmmоn structures too.

You’ll lеаrn the bаѕiс attributes, аdvаntаgеѕ, and diѕаdvаntаgеѕ оf each structure. Aftеrwаrd, уоu’ll be аblе to properly аѕѕеѕѕ whiсh орtiоn is right for уоu.

Business Entity Types

The type of business entity you select will be determined by three primary considerations: liability, taxation, and record-keeping. Here’s a quick rundown of the distinctions between the most common types of business entities:

The most common type of business organization is a sole proprietorship. It’s simple to set up and gives the owner complete managerial control. However, the owner is personally liable for all of the company’s financial obligations.

A corporation is a legal entity formed for the purpose of conducting business. The corporation becomes a separate entity from those who founded it, handling the organization’s responsibilities. The corporation, like a person, can be taxed and held legally liable for its actions.

Business Entity Types

Profitability is also possible for the corporation. The primary advantage of corporate status is the elimination of personal liability. The primary disadvantage is the high cost of forming a corporation, as well as the extensive record-keeping required.

While double taxation is occasionally mentioned as a disadvantage of incorporation, the S corporation (or Subchapter corporation, a popular variation of the regular C corporation) avoids this situation by allowing income and losses to be passed through on individual tax returns, much like a partnership.

The limited liability company (LLC), a hybrid form of partnership, is gaining popularity because it allows owners to reap the benefits of both the corporation and partnership forms of business. The benefits of this business structure are that profits and losses can be passed through to owners without the business being taxed, and owners are protected from personal liability.

Choosing a Business Entity

There are several criteria to consider when deciding on the type of business to start. When Kalish and EnviroTech co-owner John Berthold decided on a business structure for their company, they focused on the following factors:

Choosing a Business Entity

1. Legal liability.

To what extent does the owner’s legal liability need to be shielded? According to Kalish, EnviroTech considered this. He and Berthold invested heavily in equipment, and the contracts they work on are significant. They did not want to take on personal liability for potential business losses. “You should think about whether your business lends itself to potential liability and, if so, whether you can personally afford the risk of that liability,” Kalish says. “If you can’t, forming a sole proprietorship or partnership might not be the best option.”

Carol Baker is the owner of The Company Corporation, a company that provides incorporation services in Wilmington, Delaware. She cites personal asset protection as an example “the primary reason our clients incorporate No one can seize your personal assets in the event of a lawsuit or judgment against your company. It is the only solid protection for personal assets available in business.”

2. The tax implications

What are the opportunities to reduce taxation based on the individual situation and goals of the business owner?

Baker points out that corporations have far more tax options than sole proprietorships or partnerships. As previously stated, S corporation status allows you to avoid double taxation, which is a common disadvantage of incorporation. According to Baker, a S corporation is available to businesses with fewer than 70 shareholder returns; business losses can help reduce personal tax liability, especially in the early years of a company’s existence.

3. The cost of establishment and ongoing administration.

However, tax benefits may not be sufficient to offset the other costs of doing business as a corporation.

One reason that business owners may choose another option, such as a sole proprietorship or partnership, according to Kalish, is the high cost of record-keeping and paperwork, as well as the costs associated with incorporation. Taking care of administrative requirements frequently consumes the owner’s time and thus incurs costs for the business.

The cost of establishment and ongoing administration

Kalish identified the sole proprietorship as a very popular type of business entity due to the record-keeping requirements and costs associated with them. It’s the same type of entity that’s in place at his other company, Nationwide Telemarketing.

“As a first option, I would always go with sole proprietorship,” he says. “I would recommend a sole proprietorship if you are the sole proprietor and own 100 percent of the business, and you are not in a business where a good umbrella insurance policy would not cover potential liability issues. There’s no reason to burden yourself with all of the reporting requirements of a corporation unless you’re benefiting from tax advantages or liability protection.”

4. Flexibility. 

Your goal is to maximize the flexibility of the ownership structure by taking into account both the specific needs of the business and the personal needs of the owner or owners. Individual requirements must be taken into account. No two business situations are alike, especially when multiple owners are involved. Nobody has the same goals, concerns, or personal financial situation.

5. Future requirements.

It’s common to be “caught up in the moment” when you’re first starting out in business. You’re preoccupied with getting the business up and running, and you rarely consider what it might look like five, ten, or even three years down the road. What happens to the company after you die? What if you decide to sell your share of a business partnership after a few years?

Ownership was a critical issue for EnviroTech. “When we started EnviroTech, our reasoning for forming it as a corporation was ownership; we wanted to be able to bring in stockholders as we grew,” Kalish recalls.

The capital of a corporation can be increased at any time through a private offering by issuing and selling additional shares of stock. This is especially useful when banks are short on funds.

Another critical question to consider is, “What do I want to happen to the business when I’m no longer around to run it?” A corporation, unlike a sole proprietorship or partnership, can be easily distributed to family members upon the death of its owner or owners.

Keep in mind that the initial business structure you choose may not meet your needs in the future. As the company grows and the owners’ needs change, many sole proprietorships evolve into another type of business, such as a partnership or corporation.

What’s the bottom line? Don’t take this very important decision lightly, and don’t base your decision on what others have done. Before settling on a specific business format, carefully consider the unique needs of your company and its owners, and seek expert advice.

Sole Proprietorship

The sole proprietorship is the most basic structure, as it usually involves only one person who owns and operates the business. If you intend to work alone, this could be the best option.

The tax advantages of a sole proprietorship are especially appealing because the business’s income and expenses are included on your personal income tax return (Form 1040). Profits and losses are first recorded on a tax form known as Schedule C, which is filed with your 1040. The “bottom-line amount” from Schedule C is then transferred to your individual tax return.

Sole Proprietorship

This aspect is particularly appealing because any business losses you incur may be offset by income earned from other sources. You must also file a Schedule SE with Form 1040 if you are a sole proprietor. Schedule SE is used to figure out how much self-employment tax you owe.

You must pay quarterly estimated tax payments on your income in addition to annual self-employment taxes. Self-employed individuals with net earnings of $400 or more are currently required to make estimated tax payments to cover their tax liability.

If your prior year’s adjusted gross income was less than $150,000, your estimated tax payments must equal at least 90% of your current year’s tax liability or 100% of your prior year’s liability, whichever is less.

The federal government allows you to pay estimated taxes in four equal installments throughout the year on April 15th, June 15th, September 15th, and January 15th.

Unlike other business structures, your earnings from a sole proprietorship are only taxed once. Another significant advantage is that you have complete control over your business—you make all of the decisions.

However, there are a few drawbacks to consider. If you choose the sole proprietorship business structure, you will be personally liable for your company’s liabilities.

As a result, you are putting your own assets at risk of being seized to satisfy a business debt or legal claim filed against you.

It can also be difficult to raise funds for a sole proprietorship. Banks and other sources of financing are hesitant to make business loans to sole proprietorships. Most of the time, you’ll have to rely on your own funds, such as savings, home equity, or family loans.

A sole proprietorship (sole prop) is the most basic and least formal business structure available to entrepreneurs in the United States. It is also, by definition, the least conducive to growth. Some essential characteristics are shared by all sole props:

Single Owner and Operator: A sole proprietorship is owned and operated by a single individual. Sole proprietors are free to hire and retain contractors, but they are not permitted to add partners or issue stock to shareholders. You must reorganize as a partnership or corporation if you want to bring in new owners or sell equity in exchange for funding.

No Formal Incorporation: Sole proprietorships are not formally organized as corporations or partnerships. Sole proprietors who conduct business under a fictitious name rather than the operator’s name are required by law to register those names with state authorities. (These are referred to as “Doing Business As” names, or DBAs.) You do not need to register a DBA if your sole proprietor conducts business under your name.

Tax Identification: If you are the sole employee of your sole proprietorship, you can file taxes using your own Social Security number. If you hire workers, you must obtain an Employment Identification Number (EIN) from the IRS. This is free and only takes a few minutes.

Separate Finances: Sole proprietors are not required by law to keep their personal and business finances separate. However, it is highly recommended that you do so for a variety of reasons, including determining whether your business is profitable, keeping track of your income and expenses for tax purposes, and providing potential creditors with an accurate accounting of your company’s finances.

Create a business checking account and apply for a small business credit card. All income should be routed to the former, and the latter should only be used for business expenses. This kills two birds with one stone: it keeps your business finances separate while also helping you build credit.

Taxation by Pass-Through: Sole proprietors do not file taxes separately from their operators. As a sole proprietor, you must attach Schedule C or Schedule C-EZ (Form 1040) to your personal tax return. If your business was profitable during the tax year, you will almost certainly be subject to self-employment tax. On Schedule SE, you will report self-employment income and calculate self-employment tax (Form 1040).

If you expect to owe more than $1,000 in tax after deducting any withholding taxes, and if your withholding taxes account for less than 90% of the taxes you expect to owe in the current tax year or 100% of the tax obligation in the previous tax year, you must make quarterly estimated tax payments. Consult our Tax Guide or a tax advisor for more information on this and other tax issues.

HOW TO EVALUATE YOUR FINANCE NEEDS BEFORE STARTING A BUSINESS

How to Develop and Use a Business Plan

How to Get Funding for Your Business

How to Define and Analyze Your Target Market

Advantages of a Sole Proprietorship

Simplicity. A sole proprietorship is extremely simple to establish. There is no requirement to file articles of incorporation, draft an operating agreement, or make public financial disclosures. In many cases, a company name does not even need to be registered. You should keep detailed records of your company’s finances, but this is not required by law.

There is no double taxation. Sole proprietors are taxed on a pass-through basis, which means that your business income is combined with your nonbusiness income for tax purposes.

Your sole proprietorship does not pay taxes on business income, which then becomes taxable personal income for you, a situation known as double taxation. You may be required to register with the appropriate tax authorities and pay local and state sales tax if you sell taxable goods or services.

The Drawbacks of a Sole Proprietorship

Personal Liability for Commercial Debts and Obligations The obvious disadvantage of a sole proprietorship is the operator’s personal liability for the business’s debts or obligations.

For example, if you buy equipment on credit and then run into trouble and are unable to meet the vendor’s payment terms, the vendor may be able to seize your personal assets (including your personal bank account, house, and car) to satisfy the debt. Shareholders of incorporated entities are not personally liable for the debts of the business.

Lenders who are hesitant. Unless you have substantial assets to put up as collateral, your sole proprietorship is unlikely to qualify for loans from traditional lenders. This is especially true for newer businesses and owners with a poor personal credit history.

You might have better luck with nontraditional online lenders, many of which cater to sole proprietors and small businesses. However, the devil is often in the details – these loans typically have high interest rates and unfavorable terms. Personal savings, loans from family and friends, and other nontraditional startup financing options are preferable.

Possibility of increased tax liability. Pass-through taxation applies to sole proprietorships. When they are profitable, they increase the total taxable income of their owners.

A significant increase in your taxable income places you in a higher tax bracket and raises your marginal rate, lowering your take-home pay proportionally. While this appears to be a good problem to have, it is not ideal for sole proprietors who run their businesses for extra money and rely on salaries or hourly wages for the majority of their income.

It is also not suitable for sole proprietors who set aside significant portions of their business income to finance equipment, inventory, or unexpected purchases.

Partnership

Consider a partnership to be a multi-member sole proprietorship. Partnerships are defined by the Small Business Administration as “a single business where two or more people share ownership” and “each partner contributes to all aspects of the business, including money, property, labor, or skill,” while sharing “in the profits and losses of the business.”

Partners, like sole proprietors, are personally liable for partnership debts and obligations by default.

Partnership

Partnerships, like sole proprietorships, are informal. “Generally, partnerships do not require any filings with state agencies,” says Shawn Toor, a business law attorney with Williams Kastner in Seattle.

“A partnership can be formed simply by two or more people agreeing to do business together and share profits and ownership control.”

Partnership Agreements

  • The legal and DBA names of the partnership
  • The duration of the partnership – either time-limited or in perpetuity
  • The partnership’s general purpose – the business activities in which it will engage
  • Each partner’s initial contributions, such as cash and property, as well as the installment schedule on which those contributions will be made
  • Procedures for contributing to the partnership in the future
  • Procedures for accepting new partners
  • Profit and loss distribution procedures for each partner, including frequency and proportionality
  • Each partner’s management responsibilities
  • Voting procedures – which issues require a vote and how many votes are required to decide in favor
  • Procedural steps for selling or transferring a partnership interest (buy-sell agreements)
  • Procedures for removing a partner
  • Procedures for continuing or dissolving the partnership in the event of a partner’s death – frequently included in buy-sell agreements.
  • Procedures for resolving disputes, such as mediation or arbitration

The majority of partnerships are governed by contracts known as partnership agreements. Partnership agreements govern issues such as:

If your company will be owned and operated by several people, you should consider structuring it as a partnership. Partnerships are classified into two types: general partnerships and limited partnerships.

A general partnership’s partners manage the business and are personally liable for the partnership’s debts and other obligations.

There are both general and limited partners in a limited partnership. The general partners own and operate the business and are personally liable for the partnership, whereas the limited partners are merely investors with no control over the company and are not subject to the same liabilities as the general partners.

Because of all the required filings and administrative complexities, limited partnerships are generally not the best choice for a new business unless you anticipate a large number of passive investors. A general partnership is much easier to form if you have two or more partners who want to be actively involved.

One of the primary benefits of forming a partnership is the favorable tax treatment it receives. A partnership does not pay taxes on its income, but any profits or losses are “passed through” to the individual partners.

Each partner files a Schedule K-1 form at tax time, indicating his or her share of partnership income, deductions, and tax credits. Furthermore, each partner is required to report partnership profits on his or her individual tax return.

Even though the partnership does not pay income taxes, it must calculate and report its income on a separate informational return, Form 1065. Personal liability is a major concern if you structure your business as a general partnership.

General partners, like sole proprietors, are personally liable for the partnership’s obligations and debt.

Furthermore, each general partner has the authority to act on behalf of the partnership, make loans, and make business decisions that affect and bind all of the partners (if the general partnership agreement permits).

Remember that partnerships are more expensive to set up than sole proprietorships because they necessitate more extensive legal and accounting services.

You can find generic partnership agreement templates online and customize them to meet the needs of your partnership. However, these templates frequently leave out critical details that could affect your interest in the partnership – or the partnership’s very existence – in the future.

A poorly drafted partnership agreement, for example, could allow one partner to bind the entire partnership unilaterally, possibly against the wishes of the other partners.

As a result, it is strongly advised that you hire an attorney to draft a customized partnership agreement on your behalf. If your budget does not initially allow for this, revisit the situation as soon as possible. To protect their own interests, your partner(s) should be willing to create a customized partnership agreement.

Partnerships are classified into three types. In the partnership agreement, you’ll specify the type of partnership you’ve chosen.

General Partnership

The most common and straightforward type of partnership is a general partnership. General partners typically share equally in the partnership’s profits and liabilities, perform equitable duties, and have equal voting rights.

The partnership agreement governs situations in which the interests and duties of the partners diverge. Many partnerships, for example, delegate executive responsibilities to a single managing partner. Others distribute profit shares based on seniority, with longer-serving partners receiving a larger share of the entity’s net income.

Limited Partnership

A limited partnership (LP), also known as a limited liability partnership, allows for the creation of a class of “limited partners” who act as passive investors in the venture. Limited partners have little to no say in the partnership’s decision-making processes or day-to-day management activities.

They are not personally liable for the debts or obligations of the partnership. They also receive profit or loss shares proportional to their interest, which is typically less than that of general partners.

Limited partnerships (LPs) are more complicated than general partnerships. They are best suited to larger, capital-intensive ventures that attract a large number of investors, rather than small, two- or three-person ventures that are easier to manage through general partnerships.

On the plus side, they are less visible than traditional corporations. “The LP agreement is typically a privately signed document,” says Jason Powell, a corporate law attorney at Bjornson Jones Mungas, PLLC in Missoula, Montana. “[LP agreements] are typically not recorded or made public, allowing for anonymity if desired.”

Collaboration

A joint venture is a limited-time and limited-scope general partnership. It’s ideal for one-time projects that necessitate the pooling of resources, such as commercial real estate development. By amending the partnership agreement, partners in a joint venture can convert the enterprise into a traditional general partnership.

A partnership agreement will protect both you and your company.

Considering starting a business with a partner? It may be difficult to discuss problems during your honeymoon period, but that is precisely when you should. When questions arise, a written partnership agreement can help guide you.

A partnership agreement, according to W. Thurston Debnam Jr., a partner with Smith, Debnam, Narron, Wyche, Story & Myers LLP, a law firm in Raleigh, North Carolina, should answer the following questions:

  • What is each partner’s financial investment? Is one investing money, while the other is investing energy? Do any of the partners own equipment that will be used in the business, and does this fact merit consideration as part of the initial investment?
  • What are each partner’s responsibilities and duties? Be specific about each partner’s role in the company’s day-to-day operations.
  • How long will a partner be entitled to a share of the profits if he or she becomes disabled? What happens to a partner’s share if he or she dies? Life insurance on all partners is a good way to deal with this issue.
  • Is it possible for the partners to have other outside partnership interests? Can there be a particular interest in similar or competitive businesses?
  • What will you do if one of your partners decides to leave? Typically, you’ll set up a buyout agreement, but it’s a good idea to decide on the terms ahead of time. You should also include a noncompete clause.
  • How will you limit the transfer of partnership interests? Can a partner transfer ownership to anyone, or is that transfer limited? This means that the remaining partners will not be partnered with someone they dislike. This is commonly used to protect the business if one of the partners divorces and his interest becomes part of the divorce settlement.
  • Is it possible for a partner to pledge his or her interest as collateral for a loan?
  • Are additional contributions required? Are partners required to make capital contributions if the business requires capital in the future?
  • How will disagreements be resolved? Typically, an arbitrator is used.

Debnam recommends that every business partnership, regardless of the individuals involved, begin with a written agreement. “It ensures that all partners are on the same page,” he says.

However, there is another reason for entering into a partnership agreement. Debnam observes that “poorly drafted agreements keep litigation attorneys in business.” “The best reason to have a good agreement is to avoid the legal fees when you have a meltdown.

Advantages of a Partnership

Responsibilities and resources are pooled. Partners, unlike sole proprietors, can pool resources without seeking outside investors or incurring debt. They can also share day-to-day management and executive decision-making responsibilities in proportion to their qualifications and abilities.

No Formal Incorporation Is Necessary. Partnerships, unlike corporations, are not required to file articles of incorporation. Most partnerships are governed by written, legally binding partnership agreements to which all partners consent for a variety of reasons, but these agreements are not required to be reviewed or filed with local or state authorities.

There is no double taxation. The income of a partnership is taxed on a pass-through basis. The income of a partnership is reported on Schedule K-1 (Form 1065), which the partnership must provide to each partner by the annual deadline. Each partner adds his or her share of the partnership income, as reported on Schedule K-1, to his or her other personal income.

Timeline that is adaptable. Partnerships do not have to exist indefinitely. If you need to pool your resources with other investors for a single project or venture but do not want to be associated with them once the project is completed, you can form a joint venture for that purpose. When the project is completed, the partnership ends, and you and your partners part ways.

The Drawbacks of a Partnership

Personal Liability for Commercial Obligations. The most significant disadvantage of a partnership, as with sole proprietorships, is personal liability for business debts and obligations. Your share of liability is proportional to your stake in the partnership; for example, if you own 30% of the partnership, you are liable for 30% of its liabilities.

Possibility of increased tax liability. Partnership income, like sole proprietorship income, is treated as personal income. If your partnership is profitable, your personal income will rise, potentially raising your marginal tax rate, increasing your overall tax burden, and decreasing your available cash.

A formal agreement is required. Although formal articles of incorporation are not required for partnerships, almost all are governed by partnership agreements. These contracts can be quite complex, and while it is possible to modify a serviceable template at a low cost, it is costly to hire an attorney to draft a customized agreement that accounts for the widest range of possible outcomes.

Human Relationships are essential. Successful partnerships are built on friendly relationships between partners – at least between general partners. A disagreement between partners, for whatever reason, can cripple or destroy an otherwise successful partnership. Before entering into a long-term partnership (as opposed to a joint venture), carefully consider your relationships with the other partners and ask yourself if you can see yourself working with them for many years to come. If you’re not sure, reconsider.

Decision-Making Processes That Are Shared. A consensus-driven decision-making process is also required for successful partnerships, especially when only two or three partners are involved. A closely held partnership may not be the best fit if you are not comfortable discussing decisions with your collaborators.

Corporation

The corporate structure is more complicated and costly than most other business structures. A corporation is a separate legal entity from its owners, and as such, it is subject to more regulations and tax obligations.

The most significant advantage for a small-business owner who decides to incorporate is the liability protection it provides. The debt of a corporation is not considered the debt of its owners, so if you organize your business as a corporation.

Corporation

You are not jeopardizing your personal assets. A corporation can also keep some of its profits without the owner having to pay taxes on them. Another advantage is a corporation’s ability to raise funds.

To raise funds, a corporation can sell stock, either common or preferred. Corporations can also exist indefinitely even if a shareholder dies, sells their shares, or becomes disabled.

The corporate structure, on the other hand, has a number of drawbacks. One significant one is increased costs. Corporations are formed in accordance with the laws of each state, each with its own set of regulations.

You’ll almost certainly need the assistance of an attorney to guide you through the legal quagmire. Furthermore, because a corporation is subject to more complex rules and regulations than a partnership or sole proprietorship, it necessitates more accounting and tax preparation services.

Another disadvantage is that the corporation’s owners must pay a double tax on the company’s earnings. Corporations are subject to both federal and state corporate income taxes, and any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.

You could pay the money out as salaries to yourself and any other corporate shareholders to avoid double taxation. Earnings paid as reasonable compensation are not subject to taxation, and the payments can be deducted as a business expense. However, keep in mind that the IRS has set limits on what it considers to be reasonable compensation.

The Small Business Administration defines a corporation, also known as a C corporation or C-corp, as “an independent legal entity owned by shareholders.”

“Creating a corporation is similar to creating a human being,” Toor says. “Corporations can be sued, sue others, own property, and exist as part of a partnership.”

According to the SBA, “the corporation itself, rather than the shareholders who own it, is legally liable for the actions and debts incurred by the business.”

This is a significant advantage for corporate shareholders when compared to sole proprietorships and partnerships, whose members are personally liable for business debts and activities.

Partnerships and sole proprietorships are subject to less regulation than C-corps. C-corps face ongoing regulatory burdens, such as the requirement to hold annual shareholder and director meetings, in addition to onerous incorporation requirements.

If you run a small business with low overhead, incorporation may be more trouble than it’s worth. Here’s a rundown of the initial and ongoing steps you’ll need to take to establish a C-corp.

Requirements for Incorporation

Corporations must be formally incorporated with state business authorities, typically the Secretary of State’s office or a similar office.

This necessitates the creation and filing of articles of incorporation, which include the following basic information about the entity:

  • DBA and company name
  • The registered address is
  • Name and address of the registered agent in charge of official correspondence
  • The activities or goals of the company
  • Director’s names and offers
  • Information on corporate stock issuance, including share count and par value
  • Officers and directors’ liability is limited (they are indemnified).
  • Incorporation time frame
  • Procedures for dissolution
  • Adoption of existing corporate bylaws (operating agreement)

Online, you can find low-cost articles of incorporation templates. Articles of incorporation templates, like partnership agreement templates, aren’t ideal. It is preferable to spend more money on custom-drafted articles of incorporation that account for a broader range of possibilities specific to your business.

How to Incorporate

To begin the incorporation process, contact your state’s secretary of state or the state office in charge of registering corporations. Inquire about business incorporation instructions, forms, and fee schedules.

It is possible to incorporate without the assistance of an attorney by following the instructions in books and software. The cost of these resources, filing fees, and any other costs associated with incorporating in your state will be your expense.

If you file for incorporation yourself, you will avoid the cost of hiring a lawyer, which can range between $500 and $1,000. The disadvantage of taking this route is that it may take some time to complete.

There’s also a chance you’ll overlook a minor but critical detail in your state’s law.

Preparing a certificate or articles of incorporation is one of the first steps in the incorporation process. Some states will provide you with a printed form that you or your attorney can fill out.

The requested information includes the proposed name of the corporation, the purpose of the corporation, the names and addresses of the parties incorporating, and the location of the corporation’s principal office.

The corporation will also require a set of bylaws that describe how the corporation will operate in greater detail than the articles, including the responsibilities of the shareholders, directors, and officers; when stockholder meetings will be held; and other details important to the company’s operation.

The secretary of state’s office will send you a certificate of incorporation once your articles of incorporation are accepted.

Once you’ve incorporated, make sure to follow the incorporation rules. If you fail to do so, a court can pierce the corporate veil and hold you and the other owners personally liable for the company’s debts.

It is critical to follow all of the corporation rules mandated by state law. You should keep accurate financial records for the corporation, separating the income and expenses of the corporation from those of the owners.

Even if the officers and directors are the same people as the shareholders, the corporation should issue stock, file annual reports, and hold yearly meetings to elect officers and directors.

Make a point of taking minutes at these meetings. Make sure to use Inc. or Corp., whichever your state requires, to identify your company as a corporation in all references to it.

You should also ensure that anyone you deal with, such as your banker or clients, is aware that you are an officer of a corporation.

Corporate Operating Contracts

In addition to the mandatory articles of incorporation, most corporations are governed by operating agreements or bylaws.
These documents detail the manner in which the corporation will be governed. They, like partnership agreements, are not required by law, but they are strongly encouraged.

Corporate Tax Responsibilities

C-corps, unlike sole proprietorships and partnerships, are not pass-through entities. They are treated as legally distinct entities from their shareholders for tax purposes.

They pay corporate income tax at federal, state, and sometimes local levels, which differ from personal income tax rates. They are also entitled to different credits and deductions than individual taxpayers.

For more information on corporate tax obligations, including forms that must be filed, contact the IRS.

Advantages of a Corporation

Owners have limited liability. C-corp shareholders are not personally liable for the entity’s debts and obligations as long as the corporate veil is preserved, which means that shareholder and business assets are kept strictly separate (not commingled).

They are not required to personally guarantee loans or credit purchases, and their personal assets cannot be seized to satisfy creditor claims.

It is simpler to generate capital. Corporations can raise capital by selling stock shares (equity). Partnerships that want to raise funds without incurring debt must either bring on new partners or compel additional contributions from existing partners.

Sole proprietors are even more constrained – they must dip into personal savings, borrow against tax-advantaged accounts, seek loans from friends and family, or pursue other less-than-ideal options.

Increased legitimacy. Incorporated entities, for better or worse, appear more legitimate to lenders, vendors, and potential customers. This credibility can open doors to lucrative opportunities, such as loans approved at more favorable terms, discounts or favorable credit arrangements on large-ticket equipment or inventory purchases, and increased credibility from sales prospects.

The C-corp is the gold standard for ambitious companies looking to raise funds from venture capitalists or private equity firms. Bryan Clayton, CEO of Nashville-based GreenPal, spoke with me about his initial decision to incorporate locally as an LLC.

“[Incorporating as an LLC] was quick, simple, and inexpensive. “We figured it was the best way to get our company off to a good start,” he says. “What we didn’t realize is that an LLC is off-limits to institutional investors.”

Any outside investors, such as private equity, angel investors, or venture capitalists, will demand that your company be structured as a…C-corp.”

Clayton also emphasizes the importance of incorporation domicile: “Delaware has an abundance of case law that is favorable to corporate structure, investors, and board members,” he says, “and is [therefore] generally accepted as the standard by the investor community.”

Employees have built-in incentives. Equity is a strong motivator for both current and prospective employees.

Corporations frequently use stock or stock options to reward performance, longevity, and other value-adds, attracting high-quality employees and incentivizing them to stay.

The possibility of becoming a partner is a comparable incentive in partnerships, but it is impractical to offer that carrot to hundreds or thousands of associates. Corporations are free to give stock to any employee they want.

The Drawbacks of a Corporation

Potential Tax Disadvantages. C-corps’ shareholder distributions are effectively taxed twice: once at the corporate level, before distributions are made, and again as personal income on shareholders’ personal tax returns.

Though corporate income tax rates tend to be lower than individual income tax rates, and most corporations use generous deductions and credits to reduce their tax burdens, that’s not always enough to offset the effects of double taxation.

Expensive and Cumbersome to Form. C-corps are expensive and cumbersome to form. Proper incorporation requires substantial legal and financial assistance, especially in heavily regulated industries.

Increased Regulatory Burden Even privately held corporations face more regulatory burdens than partnerships or sole proprietorships. If personal liability protection and increased capital-generation potential do not outweigh these considerations, consider a lower-key business structure.

There are numerous potential stakeholders. Larger corporations may have hundreds or thousands of individual voting shareholders, all of whom must be kept up to date on the company’s activities and given a say in its direction. This necessitates a significant investment in both financial and human resources.

Even in more closely held corporations with tens of voting shareholders, the potential for conflict is greater than in general partnerships, which typically involve only a handful of egos.

Larger shareholders can cause a lot of trouble when they’re determined to throw their weight around, as numerous clashes between publicly traded firms’ boards and activist investors attest.

S Corporation

Small-business owners prefer the S corporation over the standard (or C) corporation. This is due to the fact that a S corporation offers some appealing tax benefits while still providing business owners with the liability protection of a corporation.

Income and losses from a S corporation are passed through to shareholders and reported on their individual tax returns. As a result, there is only one federal tax to pay.

S Corporation

Furthermore, S corporation owners who do not have inventory may use the cash method of accounting, which is simpler than the accrual method. Income is taxed when it is received, and expenses are deductible when they are paid, under this method.

S corporations have become even more appealing to small-business owners as a result of recent tax law changes brought about by the Small Business Job Protection Act of 1996. Previously, S corporations could only have 35 shareholders.

The number of shareholders was increased to 75 by law in 1996. According to tax experts, increasing the number of shareholders allows for more investors and thus attracts more capital.

S corporations do have some drawbacks. For example, they must comply with many of the same requirements as corporations, which means higher legal and tax service costs.

They must also file articles of incorporation, hold meetings of directors and shareholders, keep corporate minutes, and allow shareholders to vote on major corporate decisions. The legal and accounting costs of forming a S corporation are comparable to those of forming a regular corporation.

Another significant distinction between a regular corporation and a S corporation is that S corporations can only issue common stock.

According to experts, this may limit the company’s ability to raise capital. Furthermore, unlike regular corporations, S corporation stock can only be owned by individuals, estates, and certain types of trusts.

Beginning in January 1998, the Small Business Job Protection Act of 1996 added tax-exempt organizations such as qualified pension plans to this list. According to tax experts, this change should help S corporations gain even more capital access because a number of pension plans are willing to invest in closely held small-business stock.

An S corporation, also known as an S-corp, is a type of incorporated entity that is best suited to small to medium-sized businesses. S-corp owners and shareholders, like C-corp owners, are immune from personal liability for business debts, obligations, and actions.

S-corps, as opposed to C-corps, are pass-through entities. Their earnings are not subject to corporate income tax; instead, they are distributed to shareholders, who pay personal income tax at the appropriate rate (usually lower than rates on wage income).

Incorporating and running an S-corp is a time-consuming process. S-corps, like C-corps, must file articles of incorporation with the appropriate authorities, as well as hold annual shareholder meetings. Operating agreements are also highly recommended.

S-corps have a few notable differences:

S Corporation Election: Following incorporation, all shareholders must sign and return IRS Form 2553. This is known as a Subchapter S election, and it designates the corporation as a pass-through entity subject to certain limitations. The Subchapter S election must be made within two months and fifteen days of the start of the tax year to which it applies, or at any time before the start of the tax year.

Shareholder Compensation: S-corp shareholders who also work as employees, such as owner-operators or executives with ownership stakes, must receive “reasonable compensation” (a salary taxed as wage income) in addition to profit distributions.

Shareholder Restrictions: S-corps are limited to 100 shareholders by law. The potential pool of shareholders is also limited: S-corp shareholders must be citizens of the United States and (in most cases) human beings. S-corps, with a few exceptions, cannot be owned by other businesses or legal structures, such as trusts.

Stock Restrictions: In contrast to C-corps, which can issue both common and preferred stock, S-corps can only issue common stock. Common shares represent equity stakes and voting rights, increasing the number of shareholders with sway over the company’s decision-making processes.

Uneven State Tax Treatment: According to the Small Business Administration, S-corps are treated uniformly under federal tax law, but they face varying treatment at the state level.

While the majority of states recognize S-corps as pass-through entities, some (such as New York and New Jersey) tax S-corp profits and shareholder income from those profits. If you live in a state where S-corps are treated differently than the federal government, you may need to file an additional state form.

More on the differences between S-corps and C-corps can be found in this blog post from Wyoming LLC Attorney – it’s required reading for entrepreneurs deciding between the two.

The Benefits of a S Corporation

Owners have limited liability. S-corps, like C-corps, limit shareholder liability. As an S-corporation shareholder, you are not required to personally guarantee business loans or expose personal assets to creditor seizure.

There is no double taxation. S-corps, like sole proprietorships, are pass-through entities. S-corps, unlike C-corps, are not subject to corporate income tax. By extension, S-corp shareholders can deduct their companies’ losses, if any, from their personal income.

“Most businesses lose money at first,” says Toor. “Because S-Corp shareholders can deduct corporate losses on their personal tax returns, S-Corps may help lessen the blow of operating at a loss.”

Raise Capital Is Easier. S-corps, as corporations, can raise capital by selling stock. Despite the fact that they are only permitted to issue common stock, they have more flexibility to raise capital on favorable terms than sole proprietorships and partnerships.

Increased legitimacy. S-corporations, like C-corporations, are incorporated entities with all the legitimacy that entails. S-corps, on the other hand, aren’t ideal for institutional investors, so you may need to re-incorporate before seeking outside equity funding.

The Drawbacks of a S Corporation

The size of the ownership class is restricted. Individual (human) shareholders cannot own more than 100 percent of an S-corp. If you need to raise a large amount of capital from a diverse group of investors, C-corp status is a better fit.

Incorporation and operation could be costly. S-corps, like C-corps, are costly and time-consuming to set up. They have high ongoing operating costs and burdens, such as the requirement for an annual shareholder meeting.

In addition, S-corp shareholders must deal with another complication: the annual Subchapter S election. That one is irrelevant to C-corp shareholders.

Compensation Requirements That Are Reasonable Because wage income is taxed at a higher rate than “reasonable compensation,” this increases the overall tax burden of S-corp shareholder-employees.

Increased Regulatory Burden and Record-Keeping. S-corps, like C-corps, face greater record-keeping and regulatory burdens than sole proprietorships and partnerships. A simpler structure is probably right for you if the costs of increased compliance outweigh the benefits.

Shareholders must be citizens of the United States. S-corp shareholders must be citizens of the United States. If you want to start a business with noncitizens living in the United States on visas, you must use a different structure.

Limited Liability Companies

Although limited liability companies, or “LLCs,” have been around since 1977, their popularity among small-business owners is a relatively new phenomenon.

An LLC is a hybrid entity that combines the best aspects of partnerships and corporations. “An LLC is a much better entity for tax purposes than any other entity,” says Ralph Anderson, CPA and small-business tax specialist at M. R. Weiser.

Limited Liability Companies

LLCs were formed to provide business owners with the same liability protection as corporations while avoiding double taxation. Earnings and losses are passed through to the owners and reported on their individual tax returns.

Does this sound like a S corporation? It is, except that an LLC provides small-business owners with even more benefits than a S corporation. An LLC, for example, has no limit on the number of shareholders it can have, whereas a S corporation has a limit of 75.

Furthermore, any member or owner of an LLC has full participation in the operation of the business, whereas limited partners in a limited partnership have no say in the operation.

To form an LLC, you must first file articles of organization with the secretary of state in the state where you intend to conduct business. In addition, some states require you to file an operating agreement, which is similar to a partnership agreement.

LLCs, like partnerships, do not exist in perpetuity. Some state statutes require the company to be dissolved after 30 or 40 years. When a member dies, quits, or retires, the company technically dissolves.

Despite their benefits, LLCs have some drawbacks. Because an LLC is still in its infancy, its tax treatment varies by state. If you intend to conduct business in multiple states, you must first determine how each state will treat an LLC formed in another state.

If you choose an LLC structure, make sure to hire an experienced accountant who is familiar with the various rules and regulations that apply to LLCs.

Even after you’ve decided on a business structure, keep in mind that the circumstances that make one type of business organization advantageous are always subject to changes in the laws. It’s a good idea to reassess your business structure from time to time to ensure you’re using the one that provides the most benefits.

The limited liability company (LLC) model, which has only been in use since 1977, is the most recent common business structure available to U.S. business owners. It is, by some measures, the most adaptable.

“LLCs are a cross between a corporation and a partnership,” Toor explains. “LLC members have the same rights and limited liability as shareholders in a corporation, and LLCs have the added benefit of being taxed as a partnership.”

Tax Treatment

For tax purposes, LLCs can be classified as corporations, partnerships, or sole proprietorships (disregarded entities), according to the IRS. The classification is determined by the number of members (shareholders) and their stated preferences (elections).

One-member (single-member) LLCs are treated as disregarded entities by default, with pass-through business income recorded on members’ personal tax returns (Schedule C or C-EZ). Single-member LLCs can file taxes using the Social Security numbers of their members – no EINs are required.

Regardless of the number of members, LLCs with two or more members are treated as partnerships. However, any LLC, including single-member LLCs, can elect to be taxed as a corporation. In addition, for certain tax purposes, such as employment and excise taxes, disregarded entities are treated as separate corporate entities.

Filing and Regulatory Requirements

LLCs, like C-corps and S-corps, must file articles of incorporation with the appropriate state authorities. Operating agreements are also strongly encouraged.

According to the SBA, state law frequently exposes LLCs to member losses – for example, when a member dies or resigns from a multimember LLC, the LLC dissolves, and the remaining members must form a new LLC if they want to continue doing business together.

Capable business lawyers can create detailed operating agreements that account for common (and not-so-common) occurrences like this.

In the future, LLCs will face lower regulatory burdens than S-corps or C-corps. “The main difference between an LLC and a S corporation is operational flexibility,” says Brian Thompson, a CPA and business attorney based in Chicago. “LLCs are not required to hold an annual shareholders’ or annual directors’ meeting.”

Advantages of forming an LLC

Owners have limited liability. LLC members, like S-corp and C-corp shareholders, are not personally liable for the enterprise’s debts and obligations.

Reduced Regulatory Requirements LLCs have less stringent regulatory requirements than S-corps and C-corps. While articles of incorporation are required and operating agreements are strongly advised, the ongoing record-keeping and reporting requirements are not as onerous.

Avoiding Double Taxation is a possibility. LLCs are not subject to corporate income tax because they are pass-through entities.

Tax simplification. Profits and losses are reported and taxed on the individual tax returns of the owners. There is no separate business tax return unless you have more than one member and elect to be taxed as a partnership, in which case Form 1065 is required. Furthermore, there is no “double taxation” of corporations, in which both the business and the shareholders are taxed.

Can apply for S-Corporation status for tax purposes. LLCs, like C-corps, can apply for S-corp status by filing a Subchapter S election within the first two months and fifteen days of the tax year.

Depending on the duties and employee status of the entity owners, this can result in a more favorable tax situation for shareholders. Consult a local tax advisor for more information on how a Subchapter S election may affect your LLC’s tax status as well as your personal tax liability (state and federal).

Non-U.S. citizens may be shareholders. Non-U.S. citizens may own shares in LLCs. This is a significant advantage over S-corps, which do not allow non-citizens to join their shareholder ranks.

Shareholders can include corporations and other legal entities. Unlike S-corps, LLCs do not limit membership to humans. Shares in LLCs can be owned by corporations, trusts, partnerships, and other legal entities.

This is an important consideration for larger ventures that frequently use LLC subsidiaries to manage financial and legal risk.

Management that is adaptable. A “member” (equivalent to a shareholder) can be an individual, a partnership, or a corporation. Members receive a percentage of the company’s ownership. You can hire management help if your idea people can’t manage their way out of a paper bag. Smaller LLCs are typically managed by their members, but this is not always the case.

Distribution that is adaptable. Profits and losses do not have to be distributed in proportion to the amount of money invested by each individual. Profits and losses cannot be allocated in a standard C corporation. Profits and losses in a subchapter S corporation (taxed as a partnership) are proportional to the number of shares held.

The disadvantages of forming an LLC

Members Are Classified as Self-Employed. LLC members are considered self-employed for tax purposes. They, like sole proprietors, must pay self-employment tax – the employer’s share of Medicare and Social Security taxes.

Possibility of increased tax liability. You can avoid double taxation if your LLC income is taxed on a pass-through basis. However, even if the business is profitable, you may face a higher marginal rate and a higher overall tax burden.

LLC members must pay self-employment taxes, which include the Medicare/Social Security tax paid by business owners, which is calculated at 15.3 percent of profits. In comparison, consider a S corporation: Self-employment tax is only levied on your salary, not your entire profit.

If you: 1) work in the business for more than 500 hours during the LLC tax year; 2) work in a professional services LLC (health, law, engineering); or 3) sign contracts on behalf of the LLC, you are subject to self-employment taxes.

There is no stock. Because you don’t have shares or stock certificates to offer, LLCs are difficult to set up if you have multiple investors or want to raise public funds. If you give outside investors a stake in the company, you must decide whether they will be managing members.

Seidel warns business owners: “Consider whether you require more flexibility in terms of corporate stock ownership, financing options, and so on. If this is the case, an LLC is probably not the best option; instead, consider forming a C corporation.”

Two’s a crowd. In most states, an LLC can only have one member: you. However, if you live in Massachusetts or the District of Columbia, you must have two members, which may be a deal breaker.

There are fewer incentives. If you want to provide benefits to yourself or your employees, an LLC is not the best option. An LLC, unlike a C corporation, cannot deduct the cost of benefits. Furthermore, because there is no stock, you cannot use stock options as an incentive for your employees.

Paperwork. LLCs must file articles of organization with the State Corporation Commission or the Secretary of State, as well as draft an operating agreement outlining the rights and responsibilities of the members.

Some paperwork, such as an application for an employer ID number (IRS Form SS-4) and selection of tax status (IRS Form 8832), must be filed only once; others (annual report, quarterly withholding and tax deposit coupons, and business bank account) must be filed on an ongoing basis. While it is not an insurmountable burden, there is more paperwork than if you were a sole proprietor.

Finally, you won’t want to make the LLC decision on your own. “Ask a specialist for advice on the best corporate form to use,” Seidel suggests. “It can make a significant difference later on.” One size rarely fits all in business, as it does in life.

Nonprofit Corporation

Nonprofit corporations are formed to carry out charitable, educational, religious, literary, or scientific endeavors. Nonprofits can receive tax-exempt status because their work benefits the public, which means they don’t have to pay state or federal income taxes on any profits they make.

To obtain tax exemption, nonprofits must file with the IRS, which is a separate process from registering with their state.

Nonprofit Corporation

Nonprofit corporations must adhere to the same organizational rules as a regular C corporation. They must also follow strict guidelines regarding what they do with any profits they make. They cannot, for example, distribute profits to members or political campaigns.

Nonprofits are frequently referred to as 501(c)(3) corporations, which refers to the section of the Internal Revenue Code most commonly used to grant tax-exempt status.

Considerations to make before deciding on a business structure

It’s not always easy to decide which structure to use for new businesses that could fall into two or more of these categories. You must consider your startup’s financial requirements, risk, and growth potential.

It can be difficult to change your legal structure after you’ve registered your company, so consider it carefully in the early stages of forming your company.

Considerations to make before deciding on a business structure

Here are some important factors to consider when deciding on a legal structure for your company. You should also plan on consulting with your CPA for advice.

Flexibility

Where do you want your company to go, and what kind of legal structure will allow it to grow? Examine your business plan to determine which structure best aligns with your objectives. Your entity should foster the possibility of growth and change rather than stifle it.

Complexity

Nothing is simpler in terms of startup and operational complexity than a sole proprietorship. Simply register your name, begin doing business, report your profits, and pay personal income taxes on it. However, obtaining outside funding can be difficult. Partnerships, on the other hand, necessitate a signed agreement outlining the roles and profit percentages.

Corporations and limited liability companies must comply with a variety of reporting requirements with state and federal governments.

Liability

Because the law considers a corporation to be its own entity, it carries the least amount of personal liability. This means that creditors and customers can sue the corporation, but they cannot seize the officers’ or shareholders’ personal assets.

An LLC provides the same level of protection, but with the tax advantages of a sole proprietorship. Partnerships share liability among partners according to the terms of their partnership agreement.

Taxes

An LLC owner pays taxes in the same way that a sole proprietor does: all profits are considered personal income and are taxed accordingly at the end of the year.

“As a small business owner, you want to avoid double taxation in the beginning,” Jennifer Friedman, chief marketing expert at Expertly.com, explained. “The LLC structure prevents this and ensures that you are taxed as an individual rather than a company.”

Individuals in a partnership can also claim a portion of the profits as personal income. To minimize the impact on your tax return, your accountant may recommend quarterly or biannual advance payments.

Every year, a corporation files its own tax returns, paying taxes on profits after expenses such as payroll. If you pay yourself from the corporation, you will have to pay personal taxes on your personal return, such as Social Security and Medicare.

Control

If you want complete or primary control over your business and its operations, a sole proprietorship or an LLC may be the best option for you. Such control can also be negotiated in a partnership agreement.

A corporation is designed with a board of directors that makes major decisions that guide the company. A corporation can be controlled by a single person, especially at its inception, but as it grows, so does the need to operate it as a board-directed entity.

The rules intended for larger organizations, such as keeping notes on every major decision that affects the company, still apply to a small corporation.

Investment in capital

If you need outside funding, such as from an investor, venture capitalist, or bank, forming a corporation may be a better option. Corporations can obtain outside funding more easily than sole proprietorships.

Corporations can sell stock and secure additional funding for growth, whereas sole proprietors can only obtain funds through personal accounts, using personal credit, or bringing on partners.

An LLC may face similar difficulties, but because it is its own entity, it is not always necessary for the owner to use personal credit or assets.

Regulations, licenses, and permits

You may need specific licenses and permits to operate in addition to legally registering your business entity. Depending on the nature of the business and its operations, it may be necessary to obtain licenses at the local, state, and federal levels.

“States have varying requirements for various business structures,” Friedman explained. “There may be different requirements at the municipal level depending on where you set up shop. Understand the state and industry you’re in as you choose your structure. It is not a one-size-fits-all solution, and businesses may be unaware of what is applicable to them.”

The structures discussed here are only applicable to for-profit companies. If you’ve done your research and are still unsure about which business structure is best for you, Friedman recommends speaking with a business law specialist.

Conclusion

The majority of new businesses in the United States choose one of the five most common business structures. I’ve included a lot of information about each on this page, but if you’re serious about starting a business and need firm guidance on the best structure for your needs, I’d recommend speaking with a business attorney.

And there’s one more thing. A sixth type of business structure that has not been mentioned here is the cooperative.

A cooperative, according to the Small Business Administration, is “a business or organization owned and operated for the benefit of those who use its services.” Profits and earnings generated by the cooperative are distributed to members, who are also known as user-owners.”

Cooperatives are more common than many consumers realize, particularly in the food industry. Hundreds of thousands of Americans shop at grocery cooperatives, which are member-owned stores that often specialize in organic or natural foods.

Millions of people buy food from massive agricultural cooperatives without even realizing it. The multibillion-dollar cooperative that owns Land O’Lakes, a popular consumer dairy brand, is a multibillion-dollar cooperative.

Though less well-known to the average grocery shopper, CHS is even larger, more diverse, and more powerful.

All of this is to say that establishing a cooperative is extremely difficult. I’ve personally been involved with two cooperatives and can attest firsthand to the enormous amount of manpower and willpower required to get one off the ground.

A cooperative may be the best business structure for your needs in certain circumstances, but it is not a one- or two-person project.

Which legal business structure is best suited to your requirements?

Secretary of State and Commerce Web Sites

The following state websites have the information you need to choose your business structure:

Alabama

Alaska Division of Banking, Securities and Corporations

Arizona Secretary of State

Arkansas

California

Colorado

Connecticut

Delaware

Florida

Georgia

Hawaii Division of Business Registration

Idaho

Illinois

Indiana

Iowa

Kansas

Kentucky

Louisiana

Maine

Maryland

Massachusetts

Michigan

Minnesota

Mississippi

Missouri

Montana

Nebraska

Nevada

New Hampshire

New Jersey

New Mexico

New York

North Carolina

North Dakota

Ohio

Oklahoma

Oregon

Pennsylvania

Rhode Island

South Carolina

South Dakota

Tennessee

Texas

Utah Department of Commerce

Vermont

Virginia

Washington

West Virginia

Wisconsin

Wyoming

How to Choose the Best Legal Structure for Your Business