When starting a business, choosing the right business structure is crucial. It affects how much you pay in taxes, your ability to raise money for your business, and the paperwork you need to file. It also affects your personal liability, which is a major factor for business owners. There are several types of business structures. They include sole proprietorships, partnerships, corporations, and nonprofit corporations. Each has different income tax rates, tax returns, and rules about handling business debts and income.
Here, you will find resources to help you determine the appropriate legal structure for your business.
Sole Proprietorships
Sole proprietorships are the simplest form of business entity. This might be the way to go if you're self-employed and have complete control over your business. It means your business income is your personal income, and you report it on your personal tax returns. There's no need for articles of incorporation, articles of organization, or a board of directors.
As a sole proprietor, you're responsible for your business's debts. This means you are personally liable for your business's debts or legal obligations. You might also have to pay self-employment tax, which covers Social Security and Medicare. The main benefit is that it's easy to start and has fewer regulations.
In a sole proprietorship, you have to get all the necessary business licenses and permits. Individuals who start sole proprietorships typically use the term DBA. This stands for "doing business as." For example, the business name of a sole proprietorship may be "John Smith, DBA John's Repair Shop." You must register your DBA with the secretary of state's office.
Partnerships
Partnerships are a type of business where two or more people share ownership. Each partner contributes to all aspects of the business, including money, property, labor, or skill. In return, each partner shares in the profits and losses of the business. The key document here is the partnership agreement. This form of business allows for pass-through taxation. This means the business income passes through to the partner's personal tax returns.
Personal liability and management structures are generally based on the type of partnership. There are also varying degrees of personal liability and tax benefits. Here are the different types of partnerships:
- General Partnership: General partners share equal responsibilities and obligations, including profits, debts, and liabilities. Taxes are paid through each general partner's personal income.
- Limited Partnership: Each limited partner's investment amount determines their personal liability. At least one of the partners must assume "general partner" status, which comes with greater liability and exposure to debts.
- Limited Liability Partnership (LLP): Limited partners are protected from much of the partnership's liabilities and debts while offering some of the tax advantages of a general partnership.
Consider consulting with a legal professional to understand the different partnerships and which type of business entity might work best for you and your business.
Corporations
The corporation is the most complex legal structure for a business. Corporations offer the best liability protections for owners and stand as their own legal entities. One way to look at it is that a corporation is treated as its own "person" for legal and fiduciary purposes. While a corporation may be sued, its officers typically are protected from liability associated with the business. There are a few different types of corporations, including C corporations and S corporations.
C corporations, or C-corps, are a common choice for businesses that plan to go public or raise significant outside funding. They offer limited liability protection. This means owners are not typically responsible for business debts and liabilities. One major feature of C corporations is double taxation. The company's profits are taxed, and then shareholders pay taxes on dividends.
In contrast, S corporations (S-corps) are designed for smaller for-profit businesses. They avoid double taxation. Corporate income, losses, deductions, and credits can flow through shareholders and get reported on their individual tax returns. This means S corporations are subject to only one level of tax. They have stricter guidelines, like limits on the number and types of shareholders.
Unlike proprietorships, partnerships, or LLCs, corporations continue operations after the owners leave.
Limited Liability Companies
The limited liability company (LLC) is best considered a hybrid of corporation and partnership. Like a corporation, LLCs protect owners from personal liability for business debts. LLCs require less paperwork than corporations. But, they are not subject to corporate tax rates unless they choose to be taxed as a corporation. This flexibility makes LLCs a popular choice for small-business owners and entrepreneurs. The key document for an LLC is the operating agreement. This document outlines the business's financial and functional decisions.
The owners of an LLC pay their business taxes as part of their personal income while enjoying protection from personal liability. They are more complex than sole proprietorships and partnerships but afford more protections. Business owners who want to shield their personal assets may consider forming an LLC.
Nonprofit Corporations
Nonprofit corporations are set up to carry out a certain mission. This mission may be a charitable, educational, religious, literary, or scientific purpose. Unlike for-profit corporations, nonprofits do not distribute profits to shareholders. Instead, the organization must keep any money earned to further its cause.
Nonprofits are eligible for tax-exempt status. This means they don't pay federal income tax on money they make related to their nonprofit purpose. They must file articles of incorporation with the secretary of state and follow strict management and operational guidelines. Nonprofits still need to file a tax return every year. They are subject to taxes on income unrelated to their exempt purpose. This structure is ideal for organizations looking to make a social impact rather than a profit.
Consulting With a Legal Expert
Consulting with a legal expert about which type of business structure is right for you is crucial. They can help you understand the rules of the Internal Revenue Service (IRS) and the state. They can also ensure you do everything correctly, like filing the annual report or understanding your business entity status. Contact an experienced business and commercial law attorney if you have further legal questions.
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