All business owners must eventually decide under which form their companies will operate. The four basic forms a business can take are sole proprietorship, general partnership, limited-liability company, and corporation. Although each form is itself a separate entity, some share similar characteristics. Each form also has its own advantages and disadvantages. Thus, the process of selecting the appropriate business form can be as individual as deciding what type of business to have in the first place.
Sole proprietorship is the simplest of all the business forms and eliminates many of the formalities other business forms may require. Not considered a taxable entity, sole proprietorship makes filing taxes as simple as reporting profits and losses on Schedule C of the owner’s personal tax return. Other than returns and reports related to employment taxes, sole proprietorship has no other tax-filing obligations. Two major tax benefits of sole proprietorship are that it allows any losses generated by the business to offset other income on the owner’s tax return, and unused losses can also be applied to prior or succeeding years.
A possible disadvantage to sole proprietorship is that it does not offer its owner limited liability. Without limited liability, a business owner can be held personally liable for any debt or obligation that the business may incur. An alternative for sole proprietorship is a business insurance policy. A comprehensive policy may cover most, if not all, of your potential liability.
General partnership is the most flexible of the major business forms, and offers the partners¿within certain limitations¿the freedom to structure their relationship as they please. Not considered a taxable entity, general partnership is seen as a conduit through which profit and loss flow directly to the partners. Three major tax benefits of general partnership are the ability to distribute profits and losses from varying sources in unequal amounts to the different partners, the ability to apportion specific tax items unequally, and the ability to use the general partnership’s losses and depreciations as deductions on the partners’ personal income-tax returns.
Some of the disadvantages of the general partnership form are that if a partner decides to withdraw from the partnership, the partnership is dissolved, and partners will be taxed on their share of income, even if the business does not distribute funds. As with sole proprietorship, you have unlimited liability and may want to consider a business-insurance policy. One reason a general partnership may be a first consideration for many is that general partnership requires no formal filing with your state government.
Limited partnership is a variation of the general-partnership form, which does require filing with your state government. This type may interest those who want protection for a partner who is an investor, but not an active participant in the business. Limited partnership helps to limit the inactive partner’s personal liability while retaining partner status. However, the passive role required by a limited partnership may affect the limited partner’s ability to claim losses generated by the partnership on their personal income tax returns.
The corporation is the most formal of all business types and is considered a separate and distinct legal entity from its owners. Because of this distinction, owners of a corporation are generally protected by limited liability.
A corporation’s owners, known as shareholders, usually manage the company centrally and delegate control of the corporation’s daily operations to its executives and officers. Shareholders receive shares in the corporation in proportion to their ownership interest. These shares may be freely transferred, although some reasonable restrictions may be imposed by a prearranged contract.
The biggest disadvantage of the corporate form is thhat it is the only form to be taxed twice. Profits are taxed once at the corporate-income level, and again as they are distributed to each shareholder at the personal-income level. However, in smaller corporations where shareholders manage and/or participate in the business, the corporation may pay no tax at all because the corporate profits are taken out by the shareholders in the form of deductible salaries, bonuses, or benefits, and are only taxed at the personal-income level. In these cases, a distribution of dividends to shareholders is rare, so double taxation never takes place. Another potential disadvantage is that corporate shareholders can lose some or all of their shares to satisfy personal debt.
For those interested in a corporation but who cringe at the thought of double taxation, in some instances a business form known as an S corporation may be considered. However, as with all business forms, there are restrictions and disadvantages that should be weighed.
The limited-liability company, or LLC, is a business form that requires a more detailed description. Although the concept of the LLC has been around for several decades, there has only recently been any significant interest in this form. Considered a hybrid of the general partnership and the corporation, the LLC in many ways offers the best of both worlds. The LLC affords its owners the limited liability of a corporation and the flexibility of a partnership, and it is likely to become the most popular form for small- to medium-size businesses.
In a LLC, members are free to form their relationships as they choose. They are also given the choice of centralized management, as in a corporation, or decentralized management, where members have the right to participate in decisions affecting the business.
In most circumstances, from a tax perspective an LLC shares the flexible nature of a general partnership. The LLC is not a taxable entity itself, and is considered a flow-through entity, so it is taxed just like a general partnership.
Probably the most attractive characteristic of the LLC is the protection it offers all its members, active or not. As the name implies, this business form affords its members limited liability. An added bonus of the LLC form is that it protects its members’ LLC interest from being obtained by creditors to satisfy personal debts. Generally, the only time a member may not be protected by limited liability is if they are required to deliver a personal guarantee in order to secure financing for the business. To form an LLC, you must file with your state government. Each state varies, so it is recommended that you thoroughly research applicable laws or consult a business advisor familiar with your type of company and the laws in your state.
Unfortunately, in business what you don’t know can hurt you, and lack of information can lead to wasting of valuable resources as well as needless exposure to a tremendous amount of personal liability. Keep in mind that this article is not exhaustive, simply an overview of the main points of the most frequently used business entities. In deciding what business form one should choose, it is important to not only look at the business’ immediate needs but to think about the changing requirements of the business as it grows and matures.
Whether you are in the planning stages or already in business, your local library, bookstores, and the Internet contain excellent sources of information on all the business forms discussed in this article. However, before establishing or changing your business status, it is again recommended that you thoroughly research your options or consult a business advisor to make sure you are making the best choices.
Erica Tibbetts contributed to this article. Matthew Miller is an attorney-at-law in Solana Beach, California. He can be reached at: (619) 259-6969.