One of the first decisions a new business owner makes is what type of legal structure the business will have. There are several different ways to set up your company, and each will have implications as far as taxes, financing, and your personal liability.
Let’s take a look at the options, and the benefits and drawbacks of each. Of course, your individual circumstances will dictate which structure makes the most sense for you, so be sure to get professional legal advice before making a decision.
A sole proprietorship is a business owned by a single individual. This is the easiest type of structure to set up. That doesn’t mean there are no regulations to follow, however. The procedure will vary from state to state, but the steps to acting as a sole proprietorship are very simple.
1. Choose a business name.
It may be your own personal name or a trade name. If you’re using a trade name, most states will require it be different from any other currently in use there. Check your state requirements and do a search with the appropriate agency to make sure the name is available.
2. Business name registration.
Many states require sole proprietors to register your Doing Business As (DBA) name—unless you are simply using your own personal name as your business name, in which case there is no need to register with your state.
3. Licenses and permits.
Most states will have a database of professions and occupations and the licenses required. Search online for your state and “professional licensing.” Also file any local paperwork required where you’re doing business, such as local permits or zoning.
4. Employee Identification Number (EIN).
This is a 9-digit number issued by the Internal Revenue Service to keep track of businesses. You’ll have to report your employees’ wages to the IRS, and will need this number. Some banks will ask for an EIN to open a business bank account. You also need it to register your business or file taxes.
It’s important for tax purposes to keep your business and personal finances separate, so set up a business bank account and get a business credit card. A sole proprietorship doesn’t offer you any personal protection from legal claims against the business, so it’s a good idea to get liability insurance, as well. You will also be personally responsible for the business’s financial obligations, so consider a business liability insurance policy too.
Depending on what type of business you’re in, you may have to report sales or other taxes. Income taxes will be filed as personal income on your individual return with a Schedule C attached. You pay all the taxes an employer would otherwise pay for you, such as contributions to Social Security and Medicare, and you may have to pay estimated taxes throughout the year. Speak with an accountant and make sure you understand and follow through on the requirements.
A partnership is when two or more people combine to share in the profits or losses of a business. Similar to a sole proprietorship, money made or lost is reported personally by the partners on their individual income tax returns. Generally, the steps to forming a partnership are similar to those for sole proprietorships, and again, may vary slightly from state to state.
There are a few different types of partnerships, but the two most common are general and limited. In a general partnership, ownership is usually shared equally between the people involved. If a different distribution is being used, you would spell that out in your partnership agreement. Limited partnerships are usually formed when one person is doing most of the actual work and another (or others) have invested money. The general partner will typically run the business, and the other partners will have limits on their involvement. Again, these would be outlined in your agreement. You are not legally required to have a written partnership agreement, but it is smart business practice to do so.
Another thing to keep in mind about partnerships is that if a partner wants to leave, the other(s) will have to buy him or her out, or dissolve the business. This is another reason it’s smart to have a written agreement, one that includes a buy-sell or buyout agreement.
In a partnership, the partners are still personally liable for all obligations of the business. That means if the business defaults, a creditor can come after your house, car or anything else you own. (Limited partners may have limited liability.)
Another aspect of a partnership is that any of the individual partners can legally commit the business to a contract, even one that the other partners may not agree with or even be aware of. Between being responsible for the business’s debt and the ability of each partner to bind the partnership to contracts, it's vitally important to trust anyone you’re considering entering into a partnership with, and to also be sure that your personalities will complement each other and you’ll be able to work together.
As with sole proprietorships, the income or loss of a partnership passes through to the owners, and is accounted for on their individual tax returns.
A corporation, or C corporation, is an independent entity for both legal and tax purposes, separate from the people who own it or run it. A corporation can raise money by selling stock, and a corporation will continue indefinitely, even if one of the shareholders dies or sells his or her shares. Owners of a corporation are not personally responsible for the financial obligations of the corporation, nor are they personally liable in case of lawsuits.
Because of this separate status, the corporation itself pays taxes; the income is not passed through to the owners’ individual tax returns. Owners would pay taxes just as any other employee of a business would: on the money they get for salaries, bonuses and other benefits. One thing to be aware of is the potential for double taxation. As an owner, you would pay taxes on whatever salary you draw from the company, but you would also pay corporate taxes on the profits of the business.
It’s a far more complicated, expensive, and lengthier process to set up a corporation. The rules for forming corporations are set by each state, and each has a list of regulations, as well. You need to prepare articles of incorporation and a set of bylaws describing how the corporation will be run. You’ll most likely need an attorney to help you with the paperwork and certifications involved.
Once you’re up and running, you’ll probably need an accountant to handle the more complicated tax calculations and filings. You’ll need to register with the IRS and state and local tax agencies, get an EIN, and pay taxes on your corporate profit. You’ll also need to pay a portion of your employees’ Social Security and Medicare taxes.
If your business qualifies according to the IRS rules, you might choose to become a special class of corporation known as an S corp. To be classified as an S corporation, you still have to become a corporation, following the general procedure outlined above.
Like a C corporation, an S corp is also a separate entity from its owners, so your financial liability would still be limited, but its profits or losses would pass through to your individual tax return. The business itself is not taxed, so you’re not open to the potential of being taxed twice.
S corporations can only issue common stock, which experts say can make it harder to raise capital. S corps can also only be owned by individuals, estates, and some kinds of trusts, so you limit the type of investors you can attract.
Limited Liability Company (LLC)
In many ways, this type of structure offers the benefits of both a corporation and a partnership. The owners are protected from having personal liability, as they would in a corporation, but an LLC follows the more streamlined structure of a partnership. To set up an LLC, you have to file with your state, and some states will also require an operating agreement, which is similar to a partnership agreement. LLCs cannot sell stock, although you can give a percentage of ownership to outside investors.
In an LLC, the owners are known as "members." Members can be people, partnerships, corporations, or even other LLCs. The profits and losses are passed through LLCs to their members, who report them on their individual returns, just as in a partnership.
As with partnerships and sole proprietorships, LLC members are considered self-employed, and have to make their own tax contributions toward Medicare and Social Security. An LLC can also request S corporation status, which may offer other tax benefits. An attorney or accountant could advise you about that, but the Small Business Administration offers a great explanation to get you started.
Why might you opt for an LLC instead of an S corporation? Filing as an LLC means less paperwork and fewer costs to get started. There are also fewer restrictions on how the profits in an LLC are shared among its members. On the downside, similar to partnerships, if a member leaves, in many states the business is dissolved, although you can put provisions about that in your operating agreement.
One very important thing to keep in mind is that you can change the organizational structure of your business if your situation changes. It’s possible to start off as a sole proprietorship and convert to an LLC or corporation. As your needs grow and change, the structure of your business can change with them. As always, it’s best to consult with your attorney and accountant about what would be most suitable for you.
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