Updated: Sep 5, 2019
When starting a business, one of your first decisions will be to choose what organizational form of business you wish to establish. Your choice of business structure determines what legal advantages you have and which income tax return form you must file.
Common business structures
There are five common structures:
1) Sole Proprietorship
4) S Corporation
5) Limited Liability Company (LLC)
A sole proprietorship is a business owned and run by one person. This is the simplest to set up and liquidate. The business owner can choose to work alone or employ others. The advantage of a sole proprietorship is that the owner receives all profits and makes all decisions for the business. Unfortunately, this also means the owner has unlimited responsibility for all losses and debts and may have to use personal assets to fix all liabilities.
A partnership is an arrangement of two or more people who join forces in owning a business. This results in shared control. By sharing assets, such as economic resources, and using each of their unique skills they can increase the chances of reaching their goals and expanding their business.
You may be asking yourself what the disadvantages are. There are three common problems when it comes to partnerships. First, profits must be shared; a percentage of profit must be negotiated for each partner. Second, when decisions about the business are shared, disagreements can occur, and it can potentially lead to an upsetting split up. Lastly, a major disadvantage of partnerships is unlimited liability. If a partner makes a decision that later becomes a financial error, every partner is liable for all losses and debts.
A corporation is a group of people (many owners) or a company (a "sole" incorporated office) that is authorized to become a legal entity and is organized under the state. Corporations can come in many different forms, but these are divided by the law of jurisdiction and are chartered into two kinds; profit and issue stock (for investors).
What are the advantages? There are several. For example, corporations have limited liability! Unlike sole proprietorship and partnerships, a corporation’s shareholders are only liable to pay the amount of their investment. The corporation entity protects them from further liability, and their personal assets are protected. Additionally, as a marvelous advantage, if a corporation is publicly held, they can sell bonds and share a substantial amount of profit!
What are the disadvantages of a corporation? When a company has many investors, the management team can operate without oversight from the owners. If a corporation is vast enough, sometimes the owners can’t keep pace with all their teams or some teams can go rogue.
Another disadvantage occurs at tax time! Income can be taxed twice when shareholders pay taxes on any dividends received and depending on the kind of corporation formed, there will be various types of payments to be made, with excessive amounts of paperwork needed for tax filing.
An S corporation is a closely held company that does not pay any income tax. Instead, the income or losses are divided among the shareholders. The shareholders must report the income or loss of their own individual income tax returns. This allows S corporations to avoid the double taxation of the income of a regular corporation.
An S corporation also has the advantage of other legal and accounting benefits. It has limited liability. The general rule is that the corporation's shareholders are not liable for any corporate debt. Another accounting benefit is payroll tax savings. Unlike sole proprietorship and partnerships, S corporations allow shareholder-employees to save on payroll taxes. For example, if an owner of S corporation earns $100,000, he or she can save around $7,000 annually on taxes, but only if the owner can fairly divide the total amount of $100,000 into $60,000 for the owner and $40,000 of dividends to the shareholders.
There are some major disadvantages to S corporations. They are limited to 100 shareholders and have only one class of stock. There are also banking and legal costs that may result in higher charges for checking accounts, loans, and other services. Frequently, the services of a good attorney is required to help with the legal aspects of starting and operating a S corporation.
Limited Liability Company (LLC)
A limited liability company (LLC) is a type of business structure allowed and limited by state statute. Each state may have different regulations, but most states do not restrict ownership. Owners are called members. Members may include individuals, corporations, foreign entities, or other LLCs. Most states will permit LLCs to have single members for those who want to be a sole member or owner.
An LLC’s advantages are amazing! Unlike a sole proprietorship where personal assets may be at risk, an LLC is considered a separate entity from its individual members. There is no maximum number of members and there is no double taxation for an LLC. Members-only pay taxes on the profits on their personal income tax returns. Health insurance can be deducted as well. A managing member can deduct up to 100% of health insurance premiums.
However, although LLCs have amazing benefits, there are still disadvantages. There are no wages; members are not allowed to pay themselves, unless elected as a corporation, without a form of profit distribution. All members of the LLC must pay taxes on all corporate profits. If a member decided not to pull any profit out during a certain time frame, that member is still liable for taxes of the amount not pulled. Also, managing members must pay self-employment tax, because any profits earned are considered earned income.
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