There are many choices of business structure, from a simple sole proprietorship to a C corporation. The right structure can help reduce administrative burdens, reduce taxes and minimize owners’ liability. To narrow the choices, it is importan to focus on some key questions: the number and type of owners there will be, the potential liability the business will face, tax needs, investment needs, and any concerns over administrative burdens.
- Sole Proprietorship – This business structure consists of one business owner and is typically used by very small businesses.
- Partnership – A partnership is used when two or more people wish to share in the proportional profits and losses of a business.
- S Corporation – Small businesses with no more than 100 owners (shareholders) can use this business structure to enjoy the benefits of incorporation but enjoy certain tax benefits (more on this later)
- C Corporation – There is no limit on the number of shareholders in a C corporation, which is one of the reasons it is chosed by large businesses, or businesses that expect to be large.
- Limited Liability Company (LLC) – This is a hybrid of a corporation and sole proprietorship or partnership
Sole proprietorships and partnerships have unlimited personal liability for business debts and liabilities. For example, if someone sues the business for personal injury, the business owners are directly liable for damages. This may be a serious problem depending on whether the nature of the business is such that the business runs significant liability risks. In limited partnerships, a limited partner does not have the same liability as a general partner as long as he does not actively participate in managing the partnership.
Corporations and LLCs, on the other hand, are entities that are separate from their owners and enjoy a shield from personal liability. Thus, the business debts are not the debts of the owners, and the owners cannot be held personally liable for them.
The sole proprietorship, partnership, and LLC enjoy a tax feature called “pass through taxation.” This means that the owners of these businesses are able to claim the profits and expenses of the business on their personal taxes.
A C corporation, however, is a separate entity that pays taxes on its profits. The shareholders, or owners, of the corporation also pay taxes on dividends that the corporation declares. Thus the potential for “double taxation.”
In an S Corporation, a shareholder must pay taxes on the business’s income whether or not he personally received any income. While an S corporation owner can reduce his taxes by declaring the business’s losses as his own, he must actively participate in the business in order to do so.
There is no real opportunity for investment in a sole proprietorship. General partnerships raise money by each person providing contributing capital for the start of the business. Corporations have shares that can be sold to raise starting cash. Each shareholder is then an owner in the business. Depending on the ownership agreement, it may also be possible to sell and transfer business interests in an LLC.
Formalities and Expenses
The formality and expense involved with forming a particular business entity vary depending on the type of structure used. The sole proprietorship is the easiest to form, as there are generally no formal state filings or expenses involved. The general partnership likewise requires no formal state filing or expenses. Both the sole proprietorship and the partnership are relatively easy to maintain and do not require the election of officers.
The C corporation, S corporation, and LLC all require state filings and involve formation and maintenance expenses. These businesses must also maintain records, elect officers, and adhere to other business formalities.