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Business Structure

Community Enhancement / Entrepreneurship / Small Business Guide / Getting Started / Business Structure

Choosing the right business structure is an important part of starting a new business and it will likely be one of the first decisions entrepreneurs make. The business structure chosen will have an impact on taxes, liability, ability to raise capital, ownership succession, and other factors.

In making this decision, it is important to seek professional advice from an attorney and accountant or other advisor, as the structure chosen will have long-term implications on a business.

There are four basic business structures and the links below detail the positive and negative elements of each:

Sole Proprietorship

The vast majority of small businesses start out as sole proprietorships. These firms are owned by one person, usually the individual who has day-to-day responsibilities for running the business. Sole proprietors own all the assets of the business and the profits generated by it. They also assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the public, you are one in the same with the business.

Advantages of a Sole Proprietorship

  • This is the easiest and least expensive form of ownership to organize.
  • Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.
  • Sole proprietors receive all income generated by the business to keep or reinvest.
  • Profits from the business flow directly to the owner’s personal tax return.
  • The business is easy to dissolve, if desired.

Disadvantages of a Sole Proprietorship

  • Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
  • Owners may be at a disadvantage in raising funds and sole proprietors are often limited to using funds from personal savings or consumer loans.
  • These businesses have a hard time attracting high-caliber employees or those that are motivated by the opportunity to own a part of the business.
  • Some employee benefits such as owner’s medical insurance premiums are not directly deductible from business income (only partially deductible as an adjustment to income).

Partnership

In a partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, and what steps will be taken to dissolve the partnership when needed. Yes, it is hard to think about a breakup when the business is just getting started, but many partnerships split up amid crisis, and unless there is a defined process, there will be even greater problems. It must be determined up-front how much time and capital each will contribute.

Advantages of a Partnership

  • Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement.
  • With more than one owner, the ability to raise funds may be increased.
  • The profits from the business flow directly through to the partners’ personal tax returns.
  • Prospective employees may be attracted to the business if given the incentive to become a partner.
  • The business usually will benefit from partners who have complementary skills.

Disadvantages of a Partnership

  • Partners are jointly and individually liable for the actions of the other partners.
  • Profits must be shared with others.
  • Since decisions are shared, disagreements can occur.
  • Some employee benefits are not deductible from business income on tax returns.
  • The partnership may have a limited life; it may end upon the withdrawal or death of a partner.

Types of Partnerships

  • General Partnership – Partners divide responsibility for management and liability as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
  • Limited Partnership and Partnership with Limited Liability – Limited means that most of the partners have limited liability (to the extent of their investment), as well as limited input regarding management decisions, which generally encourages investors for short-term projects or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.
  • Joint Venture – A joint venture (JV) acts like a general partnership, but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such, as well as distribute accumulated partnership assets upon dissolution of the entity.

Corporation

A corporation chartered by the state in which it is headquartered is considered by law to be a unique entity, separate and apart from those who own it. A corporation can be taxed, it can be sued, and it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes.

Advantages of a Corporation

  • Shareholders have limited liability for the corporation’s debts or judgments against the corporations.
  • Generally, shareholders can only be held accountable for their investment in stock of the company. (Note, however, that officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.)
  • Corporations can raise additional funds through the sale of stock.
  • A corporation may deduct the cost of benefits it provides to officers and employees.
  • A corporation can elect S corporation status if certain requirements are met. This election enables the company to be taxed similar to a partnership.

Disadvantages of a Corporation

  • The process of incorporation requires more time and money than other forms of organization.
  • Corporations are monitored by federal, state, and some local agencies and as a result may have more paperwork to comply with regulations
  • Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible from business income; thus it can be taxed twice.

Subchapter S Corporations

An S corporation (S-corp) is a tax election only; this election enables the shareholder to treat the earnings and profits as distributions and have them pass through directly to their personal tax return. The catch here is that the shareholder, if working for the company, and if there is a profit, must pay him/herself wages, and must meet standards of “reasonable compensation.” This can vary by geographical region, as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit. If you do not do this, the Internal Revenue Service (IRS) can reclassify all of the earnings and profit as wages and you will be liable for all of the payroll taxes on the total amount.

Limited Liability Company

A limited liability company (LLC) is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The owners of an LLC are referred to as members. Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations, or other LLCs.

Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are passed through the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.

Like a corporation, an LLC can also apply for S-corp status. The organization remains a limited liability company from a legal standpoint, but is treated as an S-corp for tax purposes. For more information on the pros and cons of S-corps status for LLCs, visit the SBA’s website.

Advantages of an LLC

  • Members are protected from personal liability for business decisions or actions of the LLC.
  • This means that if the LLC incurs debt or is sued, members’ personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means “limited” liability – members are not necessarily shielded from wrongful acts, including those of their employees.
  • An LLC’s operational ease is one of its greatest advantages. Compared to an S-corp, there is less registration paperwork and there are smaller start-up costs.
  • There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity.
  • Consequently, it is up to the members themselves to decide who has earned what percentage of the profits or losses.

Disadvantages of an LLC

  • In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways. Provisions, however, can be included in operating agreements to prolong the life of the LLC if a member decides to leave the business.
  • Members of an LLC are considered self-employed and must pay the self-employment tax.