From the onset, business owners and entrepreneurs are faced with a host of pressing decisions. In the midst of considering their products and services, finding locations and personnel, and securing funding and purchasing equipment, business leaders must decide upon the type of business structure that best suits their entity. This decision has a cascade of consequences. The control of company decisions, the level of personal liability, the ways in which the company can raise money and the manner in which the company will be taxed all hinge upon how the business is legally structured.
How do you know which business structure to use as you establish your company? Below, we’ve detailed some of the basic advantages and disadvantages of each business structure so that you can go into this decision armed with knowledge and understanding.
Types of Business Entity Structures
A sole proprietor is someone who owns an unincorporated business by himself or herself. You make all of the decisions, but you also take on all of the risk. Sole proprietorships offer no asset protection for liability purposes, no estate planning benefits and no tax benefits. Instead, sole proprietors report profits and losses on their individual income tax returns.
The advantage to being a sole proprietor is that it is cheap and simple to form sole proprietorships. Sole proprietors do not need to file with the state to establish their business, and they are not subject to public disclosures or annual report requirements. If a sole proprietor wishes to operate the business under a name different from her own, she will be required to file a DBA (Doing Business As) form with her state or county, but other reporting obligations are relatively minimal.
Perhaps you are someone who does not relish the idea of being the sole decision-maker. Or perhaps the ideas and capital from your business were hatched in collaboration with another player. Whatever the reason may be, general partnerships are an easy way for business owners to share the responsibilities and profits of a company. As with the sole proprietorship, you do not need to file any formation paperwork with the state to begin a general partnership.
That said, most partnerships would benefit from a partnership agreement. A partnership agreement specifies the working relationship between the partners from the outset. It may include such details as which assets each partner contributes and the manner in which profits will be shared. It also articulates how each partner can handle their share of the company. For example, a partnership agreement may restrict a partner from transferring his stake in the company, or from putting it up as collateral for a loan.
In terms of taxes, at first glance, general partnerships may seem very attractive. A general partnership does not pay corporate or partnership taxes. Instead, the partnership files an informational tax return to the IRS. The profits and losses in that report then pass through to the partners, who report them accordingly on their individual tax returns.
While the avoidance of corporate taxes may seem like a huge advantage, general partnerships also present hefty disadvantages in terms of liability. Like the sole proprietorship, general partnerships offer no asset protection, which means that each partner is fully liable for the entire amount of the business’s financial obligations and is at risk of losing personal assets if the business is sued.
C Corporations are the most common type of corporation formed in the United States. They offer distinct advantages in terms of fundraising and estate planning, but typically require more complicated accounting and legal services to manage the heightened regulations.
One of the biggest gains from establishing a C Corporation is the liability protection it offers. Because a corporation is an independent legal entity, the business owner’s personal assets are no longer at risk. In other words, a corporation’s debt is not considered the debt of its owners, and an owner’s property is not considered the property of the corporation. A corporation is able to retain a portion of the profits without the owner having to pay taxes on it. A corporation also has the ability to raise money through the sale of stock. Because the corporation is designed as an independent entity, it can continue to exist beyond the life of the owner, allowing ownership to be transferred as part of an estate plan.
The downsides to forming a corporation include the heightened regulatory complexity and increased tax rates. To form a corporation, a business owner must file articles of incorporation with the secretary of state or the appropriate state office. Owners will need to draft a set of bylaws for the corporation, detailing how the corporation will be run, including the responsibilities of directors, officers and shareholders, and a schedule for shareholders’ meetings. The corporation is also responsible for issuing stock, filing annual reports, and holding yearly meetings to elect officers and directors. All such meetings and decisions must be clearly documented through official minutes , and those minutes will be subject to review. Most business owners require the services of a business attorney to navigate the regulatory requirements involved in forming a corporation, which adds to the initial start-up costs.
In regard to taxes, corporations are subject to corporate tax rates. In addition, the business’s earnings are essentially taxed twice, once through the corporate tax rate at both the state and federal level, and again when earnings are distributed to shareholders. This higher level of taxation may give some business owners pause when trying to decide whether or not to incorporate.
The Limited Liability Company (LLC)
In comparison with the other business structures, the limited liability company (LLC) is a relative newcomer, having only existed since 1977. The appeal of LLCs lies in the way they offer a kind of hybrid between a general partnership and a corporation. As the name implies, LLCs offer the limited liability assurances that corporations offer without the penalty of double taxation. Instead, earnings and losses pass through to the owners and appear on their individual tax returns, as they do in a partnership.
Forming a LLC is considerably less complicated than forming a corporation, though business owners do have to file articles of organization with the secretary of state. Some states require owners to file an operating agreement, which is similar to a partnership agreement, as well.
Types of Business Structure: Understand What Works for Your Business
Starting a business is a time of many important decisions. Understanding how different business structures might affect your company’s future is essential to moving forward with your goals. If you have further questions about business structures in regards to your entity management strategy, consult with a trusted advisor or contact a Blueprint representative.