All About Legal Business Entities
There are many advantages as well as disadvantages of each business structure that will be discussed. After analyzing and understanding the different types of business structures, an employer should go through each business structure to see which one suits their particular business.
Whether you’ve purchased an existing business or want to start a new company, you must first decide which form of organization (or “business entity”) is best for you. There are several business types, and each has advantages and disadvantages. Make sure that you consult with your attorney or accountant about which type of business is most beneficial for your particular situation before making a final decision.
WHAT IS A SOLE PROPRIETORSHIP?
A sole proprietorship is the simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and you, the owner. You are entitled to all profits and are responsible for all your business’s debts, losses and liabilities.
Advantages of a Sole Proprietorship
Easy and inexpensive to form: A sole proprietorship is the simplest and least expensive business structure to establish. Costs are minimal, with legal costs limited to obtaining the necessary license or permits. You would need to register the business and file an SS 4 form that will give you a Tax ID number. You might also like to set up a Merchant Account if you are a retail or wholesale business that would like to accept credit cards.
Complete control. Because you are the sole owner of the business, you have complete control over all decisions. You aren’t required to consult with anyone else when you need to make decisions or want to make changes.
Easy tax preparation. Your business is not taxed separately, so it’s easy to fulfill the tax reporting requirements for a sole proprietorship. The tax rates are also the lowest of the business structures. You would need to file SE form (self employment tax) plus Schedule C, which will record your profits and losses. It will all be reported as individual income.
Disadvantages of a Proprietorship
Unlimited personal liability. Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions.
Hard to raise money. Sole proprietors often face challenges when trying to raise money. Because you can’t sell stock in the business, investors won’t often invest.
Banks are also hesitant to lend to a sole proprietorship because of a perceived lack of credibility when it comes to repayment if the business fails.
Heavy burden. The flipside of complete control is the burden and pressure it can impose. You alone are ultimately responsible for the successes and failures of your business.
WHAT IS A GENERAL PARTNERSHIP?
A general partnership is a business entity in which two or more co-owners engage in business. The partners own the business assets together. Unless a partnership agreement states otherwise, business profits are shared by the partners equally, and each general partner has an equal right to participate in management and control of the business.
In a general partnership, business profits are shared by the partners equally and each partner is taxed on the net profits of the business. In addition to income tax on the profits, each partner must pay self-employment tax up to the tax limit of Social Security and Medicare.
Each partner is personally liable for business debts, and other liabilities. Each partner is jointly liable for the debts of the partnership. If the partnership cannot pay its debts, the partners’ personal assets are subject to liquidation to pay the business debts. Partnerships do not have a perpetual existence, because the partnership terminates upon the death, disability, or withdrawal of one partner.
WHAT IS A C CORPORATION?
The standard corporation, or C Corporation, is a separate legal entity owned by shareholders. You form the corporation by filing incorporation documents with your state and paying the related filing fees. The corporate structure limits each owner’s (shareholder’s) personal liability for the corporation’s business debts to the amount invested in the company by the shareholder. The big drawback of a C Corporation is that since the business is its own entity, the business itself is taxed. You file form 1120 with the IRS and the business income is taxed. Then the shareholders must also report their profits on their own individual tax returns. So essentially profits of a C Corp are taxed twice.
There are also many legal requirements required for a Corporation. Bylaws, mission statements and a Board of Directors must be formed. Tax planning needs to be done and since it is complex you would usually need the services of an attorney.
Who Should Consider A C Corporation?
A C corporation might be the right business type for you if you:
May need venture capital for financing.
Want company earnings to stay in your business so that it can grow.
Want flexibility to spread the business earnings between the corporation and shareholders for tax-planning purposes.
Want flexibility to provide (through the corporation) substantial health and medical benefits and other fringe benefit programs for things like education, life insurance, and transportation costs.
Want to be able to easily sell your business.
Want to provide an accountable plan for travel & entertainment.
Want to be able to offer stock options to employees.
Prefer to lower your risk of IRS audit exposure , since there is a higher audit rate for business income that is reported solely on Schedule Cof Form 1040 (U.S. Individual Income Tax Return).
WHAT IS AN S CORPORATION?
An S Corporation Is A Standard Corporation That Has Elected A Special Tax Status With The IRS. The Formation Requirements Are The Same As Those For C Corporations: Incorporation Documents Must Be Filed With The State And Appropriate Filing Fees Paid. The S Corporation’s Special Tax Status Eliminates The Double-Taxation That Can Occur With A C Corporation’s Income. A Corporate Income Tax Return Is Filed, But No Tax Is Paid At The Corporate Level. Instead, Business Profits Or Losses “Pass-Through” To Shareholders And Are Then Reported On Their Individual Tax Returns. Any Tax Due Is Paid By Shareholders At Their Individual Tax Rates.
Who Should Consider An S Corporation?
An S corporation might be the right business type for you if:
You want to take advantage of benefits that the corporate business type holds, but you want to take advantage of pass-through taxation.
Lower risk of IRS audit exposure is desired, because S corporations file an informational tax return (Form 1120 S U.S. Income Tax Return for an S Corporation) and there is a higher audit rate for business income that is reported solely on Schedule C of Form 1040 (U.S. Individual Income Tax Return).
KEY DIFFERENCES BETWEEN C CORPORATIONS AND S CORPORATIONS
While C corporations and S corporations may seem very similar, there are big differences:
Taxation. C corporations are separately taxable entities and file a corporate tax return, reporting profits or losses. Any profits are taxed at the corporate level, and losses don’t pass through for use by the shareholders to offset other taxable income. The profits of C corporations face possible double taxation when corporate income is distributed to shareholders as dividends. First, the corporation pays tax on its corporate income; then, the shareholders pay personal income tax on the same income when it is distributed to them as dividends. S corporations, however, are pass-through tax entities so there is no tax paid at the corporate level. Profits and losses are passed-through the corporation and reported on the shareholders individual tax returns. Any tax due is then paid by the shareholders at their individual tax rates.
Corporate ownership. C corporations can have an unlimited number of shareholders, while S corporations are restricted to no more than 100 shareholders. Also, C corporations can have non-US citizens/residents as shareholders, but S corporations cannot. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships, or many trusts. C corporations are not subject to those same restrictions
WHAT IS A LIMITED LIABILITY COMPANY?
The Limited Liability Company (LLC) offers an alternative to corporations and partnerships by combining the corporate advantage of limited liability protection with the partnership advantage of pass-through taxation. With this tax status, the LLC’s income is not taxed at the entity level; however, the LLC typically completes a partnership return if the LLC has more than one owner. The LLC’s income or loss is passed through the LLC and reported on owners’ individual tax returns. Tax is then paid at the individual level.
You form an LLC by filing incorporation (organizational) documents with your state and paying the related filing fees. LLCs also have fewer ongoing formalities and obligations than corporations.
WHO SHOULD CONSIDER AN LLC?
AN LLC MIGHT BE THE RIGHT TYPE OF BUSINESS FOR YOU IF:
You want management flexibility, since LLCs offer more flexibility than corporations in terms of how the management of the business is structured.
You wish to minimize ongoing formalities. Unlike corporations, which are required to hold annual meetings of directors and shareholders and keep detailed documents and records for all corporate meetings and major business decisions, LLCs do not face strict ongoing meeting and documentation requirements.
You want flexibility for sharing profits among owners.
Disadvantages of an LLC
Taxes will be higher since they are usually subjected to self employment tax
No bylaws, or Board of Directors leads to confusion about who is in charge, so it will be harder to find investors
Can’t sell or give stock options to employees. Can only sell percentage of business, making it hard to sell the business.