There are pros and cons to each type of business structure, and it’s important for every business owner to understand the benefits (and possible drawbacks) of each entity.
The Risks of Sole Proprietorships
This form of ownership is for a single owner who wants to start a business. A sole proprietorship is the simplest business structure, because it does not require the owner to set up a separate legal entity (although you should create a fictitious name). The profits and losses pass through directly to the owner’s personal tax return, using Schedule C.
The sole proprietor structure has some drawbacks, however. To grow your business, you’ll probably need to raise more capital, and it’s difficult to raise additional capital as a single owner. If your intention is to grow your business into a large operation, a sole proprietorship is not the best structure for you.
This structure also exposes the owner to unlimited personal liability for business risks. While a sole proprietorship allows you to get up and running quickly, you’re legal risk is higher than any other type of business structure.
LLCs: Are They Worth the Investment?
To avoid the unlimited liability issues of operating a sole proprietorship, many owners set up limited liability corporations (LLCs). LLCs pass through profits to the owner, but also limit the owner’s legal liability. You can have an unlimited number of members in your LLC, which makes it easier to raise capital and expand your business.
You will incur costs to setup your LLC with your state and maintain your LLC status. Setting up an LLC is more complex, because your have to choose a tax status and create an operating agreement. However, many business owners feel that the flexibility offered by an LLC is worth the extra time investment.
Is Your Business Ready to Be an S Corp?
When you form an S corp, you issue stock to each of the owners, who are referred to as shareholders. Since the S corp is a business entity, its shareholders are protected from many forms of business legal liability. Profits pass through to the shareholders, and each shareholder has the right to sell their shares. This type of corporate structure makes it easier to raise capital, and an S corp has an unlimited life.
There are some limitations to the S corp structure. Current tax law limits the number of shareholders to 75, and only one class of stock can be issued. An S corp must also consider the amount of compensation paid to the managers who operate the S corp. The IRS has rules regarding reasonable compensation paid to S corp business managers.
Forming an S corp is complex, and the tax reporting requirements to maintain your S corp status can be extensive. If you choose this type of corporate structure, hire a CPA or an attorney to help you with the paperwork.
Partnerships Come in Different Shapes and Sizes
In a partnership, two or more people operate a business using a partnership agreement. The partnership can take several forms, but the most common arrangement requires at least one general partner and possibly a group of limited partners.
A general partner is typically involved in the management of the partnership. As an example, many law firms and accounting firms are partnerships, and are managed by general partners. General partners have unlimited legal liability, and that liability extends to their personal assets. In addition, every partner is liable for the actions of other partners while conducting work for the partnership.
Limited partners, on the other hand, are not involved in the management of the partnership, and their liability is limited to their investment in the partnership.
Partnerships are pass through entities, so each partner’s share of profits is included on his or her personal tax return. The process of filing a partnership return may be complex, however. The partnership must file a tax return that lists each partner’s share of profit, and the dollar value of each partner’s ownership share (basis).
C Corps Offers More Protection, More Taxes
A C corporation (C corp) is not a pass through entity, because the corporation files a tax return and pays taxes as a corporation. If you choose to form a C corp, you must follow the incorporation rules for your particular state, and you’ll be required to file annual financial statements. Earnings are taxed at both the corporate level and on the owner’s personal tax return.
Your legal liability as a C corp shareholder is limited to the dollar amount of equity you own. A C corp offers the strongest level of legal liability protection for the owners. Also, a C corp is the best way to raise capital, since you can continually issue more shares of stock, and your business has an unlimited life.
Your C corp requires more legal and regulatory reporting than any other type of business structure, and you must file a corporate tax return.