Which Business Structure is Right for You?
Which entity is best for your business depends on many factors, and the decision can have a significant impact on both profitability and asset protection afforded to its owners. Below is an overview of the most common business structures. You should consult an attorney to determine which structure is the best choice for your business.
The sole proprietorship is the simplest and least regulated of all business structures. For legal and tax purposes, the sole proprietorship’s owner and the business are one and the same, and the income and expenses of the business may be reported on Schedule C of a personal income tax return. The liabilities of the business are personal liabilities of the owner, and the business terminates when the owner dies. On the other hand, all of the profits are also personal to the owner and the sole owner has full control of the business.
A partnership consists of two or more persons who agree to share profits and losses. It is simple to establish and maintain; no formal, written document is required in order to create a partnership. If no formal agreement is signed, the partnership will be subject to state laws governing partnerships. However, to clarify the rights and responsibilities of each partner, and to be certain of the tax status of the partnership, it is important to have a written partnership agreement.
Each partner’s personal assets are at risk. Any partner may obligate the partnership, and each individual partner is liable for all of the debts of the partnership. General partners also face potential personal legal liability for the negligence of another partner.
A limited partnership is similar to a general partnership, but has two types of partners: general partners and limited partners. General partners have broad powers to obligate the partnership (as in a general partnership), and are personally liable for the debts of the partnership. If there is more than one general partner, each of them is liable for the acts of the remaining general partners. Limited partners, however, are “limited” to their contribution of capital to the business, and must not become actively involved in running the company. As with a general partnership, limited partnerships are flow-through tax entities. Limited partnership are often used as investment vehicles in which most the investors will not be involved in managing the partnership, and they are also traditionally employed by wealthy families for asset protection and reduced exposure to the federal estate tax.
Limited Liability Company (LLC)
The LLC is a hybrid type of business structure. An LLC consists of one or more owners (“members”) who may actively manage the company’s business affairs. The LLC contains elements of both a traditional partnership and a corporation, offering the liability protection of a corporation, with the tax structure of either a sole proprietorship (if it has only one member), or a partnership or an S-corporation (at the company’s election, if the LLC has two or more members). It is important to note that in certain states, single-member LLCs are not afforded complete limited liability protection.
It is important to have your attorney prepare an operating agreement for an LLC that establishes the company’s governance and the rights and responsibilities of the members. Operating agreements establish who will be in charge of managing the LLC, what percentage of membership interests are required to make major decisions, to whom and under what conditions members can sell their interests, and can even include survivorship provisions to avoid the need to probate the LLC membership interest upon the death of a member.
Corporations are more complex than either a sole proprietorship or partnership and are often subject to more state regulations regarding their formation and operation. From a tax perspective, there are two basic types of corporations: C-corporations and S-corporations. There are significant differences in the tax treatment of these two types of corporations, however, they are both generally organized and operated in a similar manner.
Technical formalities should be observed in order to reap the full benefits of corporate existence. For this reason, there is an additional burden of detailed recordkeeping. Corporate decisions must be documented in writing. Corporate meetings, both at the shareholder and director levels, must be formally documented with minutes.
Corporations limit the owners’ personal liability for company debts. Depending on your situation, there may be tax advantages to incorporating, and a corporation has the utmost flexibility in issuing shares as compensation to employees and in defining different share classes.