Choice of Business Form
There are a number of different choices of business forms, each with its own advantages and disadvantages. Like the people who are starting them, each business is unique and what business form to choose must balance those unique characteristics. Here is a brief overview of some of the more common business forms.
Sole Proprietorship
A sole proprietorship is the simplest form of business to start. It is the default business form when a single owner starts a business. It has no legal identity apart from the owner. Business income is taxed to the owner as individual income, and the owner may claim deductions for the business expenses. For all its ease of operation, the major drawback is the owner is personally liable for all claims against the business. That means, although a lawsuit may arise out of something exclusively involving the business, the owner’s personal assets would be at risk to satisfy any judgement.
General Partnership
A general partnership is simply a group of two or more people (or entities) engaged in a business venture for profit. Like a sole proprietorship, a general partnership is a simple form of business to create. It is so simple, that partners may not have even intended to form a partnership, but by course of action had done so. By default, income is taxed on a per capita basis, meaning divided equally among the number of partners. Allocation of ownership interest can be changed by the terms of a partnership agreement. Each partner is also personally liable against any claim against the partnership regardless of personal fault.
Limited Partnership
A limited partnership is an organization created by agreement which contains at least one general partner (who bears the risk of unlimited liability), and one limited partner (who’s risk is limited only to their ownership interest). This is a type of organization that is suitable for those who are raising money to finance their business venture (the general partner) and those who are investing their money in that business venture (the limited partner). The cost of the limited partner’s lack of liability is a bar on their participation in the management of the business.
Corporation
A corporation is a business entity that allows for multiple owners and limited liability. Each owner (shareholder) risks only their investment in the corporation. One of the features of a corporation is the transferability of ownership interest. This make the corporation attractive to investors, and allows the business to raise capital. To form a corporation, you must file articles of incorporation with the state, and there are annual filing requirements that must be satisfied.
Unlike the other business formations, the corporation is considered a separate tax paying entity, and will be taxed on its profits. The shareholders will also be taxed on dividends paid by the corporation. This is referred to as double taxation.
S Corporation
An S Corporation, or S Corp, is a qualifying corporation that files under subchapter S of the Internal Revenue Code. Apart from its qualifications, it is simply a corporation with no separate formation requirements. The S Corp allows the corporation to be treated like a sole proprietorship, or a partnership for tax purposes. This means the S Corp will not be subject to double taxation. The qualifications to file under subchapter S are generally a limit of corporate profits and the number (and identity) of shareholders.
Limited Liability Company
A Limited Liability Company (LLC) combines the liability protection benefits of a corporation with the tax characterization and operational flexibility of a partnership. Each owner of the LLC (called a member) could be an individual, a partnership, or a corporation. If the LLC will have two or more members, an operating agreement should be drafted to memorialize the terms of operation, the percentages of ownership, allocation of profits, and member’s rights and responsibilities. A LLC has annual filing requirements, but are generally easier to operate then a corporation. One drawback to a LLC is each member is considered self-employed and must pay self-employment tax contributions to Medicare and Social Security on all LLC net income.