What form of organization to choose when you start your business?
Whether you just have been started working for yourself or are just thinking about your business, one of the first tasks you have to solve is to decide on the form of ownership of the company. Your company’s form will affect: how you are taxed, your legal liability, costs of formation, operational costs.
Here’s a list of the most common ways to organize a business:
- sole proprietorship
- limited liability company (LLC)
- corporation (for-profit)
- nonprofit corporation (not-for-profit)
1. Sole Proprietorship
It’s the most common and the simplest type of business ownership. This form of organization means a business owned and run by someone for their own benefit. It doesn’t require to be registered with the state. Only if the business is conducted under a name other than the surname of the owner, then an assumed name certificate (DBA) should be filed with the state or county.
- Very little regulation;
- Low startup cost;
- All profits are subject to the owner;
- Just a few requirements for starting—usually it’s only a business license;
- The owner is 100% liable for all business debts. Meaning you could lose everything you own if the business fails or loses a major lawsuit;
- Equity is limited to the owner’s personal resources – limited sources of financing — based on your creditworthiness;
- Ownership of proprietorship is difficult to transfer;
- Limited lifespan — the business ends when the owner dies.
Filing: You don’t need to file any papers to set up a sole proprietorship – you create one just by going into business for yourself.
For whom is this option? It is very easy to start and a good option for someone starting a low-risk business on a trial basis, with no additional taxation. But in this case, the business owner is personally liable for any obligation the business may have. Profits are the income of the owner, and losses are deductible to the owner.
2. Partnership – General and Limited
There are 2 forms of partnerships, General and Limited. In a general – all owners have unlimited liability and in a limited – at least 1 partner has liability limited only to his investment while at least 1 other partner has full liability. Most states require the “Articles of Partnership” that contain details about each partner’s investment and role in the new company. It’s the simplest type of business ownership when two or more people are involved.
- ease of organization – simply creating the articles of partnership
- combined knowledge and skills
- bigger borrowing capacity
- little government regulations
- all business debts are personal debts
- all money earned has to be shared and distributed to the partners per the articles of partnership
- each partner is responsible for the actions of all the others
- risk of disagreements among the owners
- limited lifespan — the partnership ends when a partner dies or withdraws.
Filing: You don’t need to file any paperwork to form a partnership, it begins as soon as you start a business with a partner. The owners pay taxes on their share of the business income on their personal tax returns and they are each personally liable for the entire amount of any business debts and claims.
For whom is this option? It’s good for a small service business in which you are unlikely to be sued and for which you won’t be borrowing much money for inventory or other costs.
Both sole proprietors and partners in a partnership may qualify for the 20% pass-through tax deduction established by the Tax Cuts and Jobs Act (TCJA).
Corporations are separate entities and are considered legal persons. This means the profits are going to be taxed as the “personal income” of the company, but then the income will be shared with the shareholders as dividends and is taxed again as the personal income of the owners.
- Limits liability of the owner to debts or losses
- Profits and losses belong to the corporation
- Can be transferred to new owners fairly easily
- Personal assets cannot be seized to pay for business debts
- Corporate operations are costly
- Establishing a corporation is costly
- Starting a corporate business requires complex paperwork
- With some exceptions, corporate income is taxed twice
An S corporation, or S corp, is a type of corporation that is meant to avoid the double taxation that hits normal C corporations. To become an S corp and avoid that taxation, you file a special election. Once the business is officially an S corp, it is no longer taxed on profits. Instead, all profits, and losses, are passed on to the stockholders. Becoming an S corp isn’t possible for everyone. If you have more than 100 stakeholders and any stakeholders that aren’t citizens of the United States, you are out of luck.
“+” no double taxation
“-” once you make a certain amount, you will be double-taxed
C corporation is a regular corporation when its own entity is separate from its owners. It offers the most protection in terms of liability. It has the sense to register when it comes to funding. A stock is a partial share in a company, so when people buy stock, they are buying ownership and decision-making responsibilities. But to start a corporation costs more than any other form of organization. Because it will require more records and reports. In some cases, there is double taxation – on profits and on the dividends. The owners are called shareholders. The persons who manage the business and affairs of a corporation are called “directors”.
C corporation is good for a businessman looking for a little more risk, good funding options, and the prospect of eventually selling stock to the public.
“+” stock provides good funding options
“-” double taxation
B (Benefit) corporation
B Corporation shareholders have the goal of providing a public benefit, but they also want to see a profit. Sometimes it will require B corps to provide benefit reports to prove they are contributing to the good of the public. B Corps are not taxed differently from C corps.
“+” serve the public while making a profit
“-” no special tax benefits
Close corporation differs from other types by availability to buy stocks. The stocks can be owned only by people that are closely related to the business. Stockholders in close corporations benefit from liability protection while also being free of reporting requirements and pressure from shareholders that don’t know much about the business.
“+” stock owned by people close to the company
“-” potential for double taxation
Filing: Formation requires filing documents with the state government.
4. Limited Liability Company (LLC)
Same as Limited Partnership LLC will provide owners with limited liability.
- Limited liability to the company owners for debts and losses;
- The profits are shared by the owners without double-taxation;
- Easy startup;
- No additional federal taxes;
- Ownership is limited by certain state laws;
- Agreements must be comprehensive and complex;
- Beginning an LLC has high costs due to legal and filing fees;
- Self-employment taxes;
- Hard to raise outside capital;
The owners of an LLC are called “members.” A member can be an individual, partnership, corporation, trust, and any other legal or commercial entity. Generally, the liability of the members is limited to their investment and they may enjoy the pass-through tax treatment afforded to partners in a partnership. As a result of federal tax classification rules, an LLC can achieve both structural flexibility and favorable tax treatment.
Corporations and LLCs
The main benefit of an LLC or a corporation is that these structures limit the owners’ personal liability for business debts and court judgments against the business.
Corporations and LLCs make sense for business owners who either run a risk of being sued by customers or of piling up a lot of business debts or giving substantial personal assets they want to protect from business creditors. LLC separates the owner’s personal and professional assets. Meaning if your business gets hit with a lawsuit or goes bankrupt, your house, car, and personal piggy bank are safe. LLCs do not pay additional federal income taxes or those associated with being a corporation. However, depending on their location, they might be subject to other state taxes. Also, LLCs fall under the category of self-employment, so those taxes fall on them as well.
For whom is this option? LLC is a good option for a business owner willing to take a little bit of a bigger risk or one looking to protect their personal assets.
Filing: Formation requires filing documents with the state government.
5. Nonprofit Corporations
Nonprofit means business related to charity, education, religion, literature, or science. Nonprofits do not pay any taxes on their income, because they exist to serve the common good. To start a nonprofit corporation you need to register with your state, follow almost the same rules as standard C corporations, and all money must go back into the organization. It means profits can not be distributed to the owners of the organization.
- serve the common good;
- free from taxes;
- all profits go back into the organization;
A cooperative is a private business owned and operated by the same people that use its products and or services. The purpose of a cooperative is to fulfill the needs of the people running it. The profits are distributed among the people working within the cooperative, also known as user-owners. There is typically an elected board that runs the cooperative, and members can buy shares to be a part of the decision-making process.
“+” employees are engaged and are only taxed on their income;
“-” hard to receive outside funding
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The article has been written based on information taken from nolo.com