Which Type Of Legal Entity Is Best For Your Business?
The most type of business structure you choose can have a big impact on future business operations and on your personal income. Popular choices include Sole Proprietorships, Partnerships, Limited Liability Companies, and Corporations. More specific legal entities can be formed within these structures. Each kind of entity allows for a different level of personal liability for the debts or expenses of the business, different methods for computing personal and business tax amounts, and different management structures.
A Sole Proprietorship exposes a business owner to the highest level of personal liability. In this type of arrangement, the business and the business owner are effectively the same. A sole proprietorship usually requires no formal documentation, and business owners pay personal income taxes on business profits. Sole Proprietorships can be an effective arrangement if:
• You are the sole manager and employee of your business
• You don’t anticipate business use of expensive personal assets (equipment, vehicles, etc.)
• You can assume personal responsibility for all business liabilities
As a sole proprietor with no formal business structure, business profits will be counted toward your personal taxable income, which might “bump” you into a higher tax bracket. You may not be able to deduct all business expenses to offset these gains. Sole proprietorships are best for businesses that are owner-operated and have little in the way of equipment costs.
A Partnership can also expose owners to a high level of personal liability, depending on the type of partnership that is chosen. Partnerships are most often governed by a partnership agreement, though no formal documentation is necessary to form a partnership. A partnership agreement specifies the responsibilities of each partner, and details how profits and losses will be shared. Partnerships do not pay taxes themselves, rather, partners pay personal income tax on profits. Limited Liability Partnerships and Limited Partnerships are types of partnerships.
A Limited Liability Partnership (LLP) operates under applicable statutory rules, and can allow partners to limit their liability for business debts. Specific documentation must be filed to form an LLP.
A Limited Partnership is a type of partnership where at least one partner is a general partner, with unlimited liability for business debts. Other partners can be limited, a status that allows a higher level of personal protection from business debt liabilities.
A Partnership might be a good option if:
• A business has more than one owner/manager/investor
• Owners want different levels of involvement in day to day business operations
• You are comfortable with the tax structure for a partnership
It is important to consider the effects of the partnership on your personal earnings. You should discuss long-range business strategies with co-owners, and determine if a specific type of partnership would suit your business goals.
A limited liability company (LLC) is similar to a partnership in some ways: it offers a flexible management structure and more flexibility in regards to tax options. “Owners” of an LLC are “members,” and they are still liable to a certain extent for the debts of the business, though generally to a lesser degree than with a partnership agreement or a sole proprietorship. LLC’s must draft and file an operating agreement, or a document that defines the rights and responsibilities of members. Consider an LLC if:
• The business may incur large debt obligations
• Several owners/managers want to be involved in the day to day business operations
• You want a business structure that allows more flexibility in governance and taxation procedures
Forming a Corporation affords the highest level of personal protection from business liability. Corporations must file certain documents with the state they choose to incorporate in, draft and file Articles of Incorporation and Bylaws, and hold annual meetings, among other things. The owners of a corporation are called shareholders. If you choose to incorporate, you have the choice of creating a C-Corporation or an S-Corporation.
A C-Corporation is a business legal entity that is almost considered “person” under the law. It pays taxes as an entity, and shareholders also pay income tax on personal earnings.
An S-Corporation is a “passes through” profits to shareholders, and is not usually taxed as an entity. There are several different restrictions on shareholders of an S-Corp.
A Corporation is used as business structure by small and large businesses alike. A corporation might be a good choice if:
• Owners seek the highest level of protection from personal liability for business debts
• Owners want a structure with flexibility with regards to their level of involvement in the business.
• Owners want the option of easily transferring ownership
An attorney can better explain the benefits of each type of business structure, and can draft all of the required documents necessary for formation. You may also want to consider an online business incorporation service, or a business that can help prepare incorporation documents.