There are a number of variables you’ll have to consider when forming your business, including legal issues, taxes and type of operations.
This article will give you an overview of the issues involved and general information about various types of business entities. There is some variation from state to state, but the options you’ll hear most about are:
- Sole Proprietorship
We’ll look at them each in turn.
The simplest and usually least expensive form of business to set-up is a sole proprietorship. The majority of single owner small businesses in the US are sole proprietorships. And many businesses start out this way because it is relatively inexpensive and involves very little paperwork to set up.
Sole proprietorships usually operate in the name of the owner, although you can also register a trade name, known as Doing Business As or DBA. To do so you’ll probably have to file a “fictitious name” certificate of some type either with your local or state government.
Sole Proprietorships can only have one owner, but there is no limitation on the number of employees or how the business runs. Generally, the owner of the sole proprietorship controls and runs the business, so there aren’t other partners or owners to contend with in the decision-making process. In sum, it’s the simplest form of business ownership and a sole proprietorship can be sold by transferring the assets to another person or entity.
The biggest downside of a sole proprietorship is that legally the business is not legally separate from the owner. This doesn’t afford the owner any protection from the business’ liabilities or creditors, nor are the business’ assets protected from the liabilities of the owner.
And with a sole proprietorship you can’t raise funds from investors, since there can be only one owner. Upon the owner’s death, the business ceases to exist. In that event, the assets of the business become part of the owner’s estate.
From a taxation standpoint, the earnings of the business are taxed at the owner’s income tax rates because the profit and loss is shown on his or her personal income tax form, usually by filing Schedule C. There is no separate business tax return that needs to be filed.
Partnerships come in two forms: general and limited.
1. General Partnership
A general partnership has two or more partners who agree to start a business and to jointly own it. Unlike a sole proprietorship where one person is in control, a general partnership has more than one owner, so life can be a bit more complicated.
It’s very important to have a written agreement that spells out how the partners will work together.
For instance, you need to be clear about:
- how the decision making process will work
- who will manage the business
- how the profits or losses will be shared
- how much time will be devoted to the business
- if there are any restrictions on other business ventures
- how much each of the partners will be paid
And don’t forget to spell out whether a partner can sell his/her interest in the partnership and how the process will work.
Although the general partnership is a separate entity, all the partners are liable together and individually for any partnership debts or judgments. So creditors could conceivably come after any partner for business debts. Also, unless provision is made for it, a general partnership usually ends upon the death of a partner.
From a taxation standpoint, the general partnership files a separate tax return, which is known as an information return. No income tax payments are made with the return; rather the profit or loss flows through to each partner’s individual tax return in proportion to his/her partnership share which is taxed at the individual partner’s rate.
2. Limited Partnership
A limited partnership has both general partners (one or more) and limited partners. The general partner is in control of the business decision making and operations.
Unlike the general partner, limited partners have limited liability. However, this limited liability protection can be breached if certain legal requirements are not followed correctly. Limited partners do not make management decisions, so they have little or no control of how the business is run.
For both types of partnership, many states require the business to file some form of partnership certificate at the state or local level. And if the partnership is using a trade name, you’ll most likely need to file a fictitious name certificate with the state or town as well.
You’ve probably heard about C corporations and S corporations. The difference between a “C” and an “S” lies in the way they are taxed. “S” corporation treatment for tax purposes requires filing an election to do so with the IRS when the business starts operating.
Corporations are separate legal entities and generally the owners are not personally liable for the corporation’s debts. The owners of a corporation are stockholders. Their percentage ownership interest in the business is shown by the number of shares of stock they hold as a percentage of all the stock issued.
Corporations have Boards of Directors who are elected by the stockholders. The corporation’s Officers (e.g., President, Vice President, Secretary, and Treasurer) are appointed to terms by the Board of Directors.
When starting a corporation, you must file incorporation papers with the state and usually this includes naming the Officers and Board Members. There are always fees involved in this, which makes setting up a corporation a bit more complicated and expensive than a sole proprietorship or partnership. You will also need corporate by-laws which delineate items such as what the Officers’ responsibilities are and which type of decisions require Board approval.
If there is more than one stockholder you may also want to consider creating a shareholder’s agreement that sets out the understanding among the stockholders as to how and when shares can be sold, what happens in the event of disability of a shareholder and similar issues.
In order to obtain the protections afforded by a corporate entity, you should be careful to understand and meet the legal requirements and avoid intermixing personal and business assets. Also, small business owners are often required by lenders to assume liability through personal guarantees, so be sure to get legal advice before doing so.
Corporations file separate tax returns from the shareholders.
If it is a C corporation, the business pays any taxes due. In a C corporation there is the possibility of “double taxation” because dividends paid to shareholders are not tax deductible to the corporation so the business pays tax on them and then the shareholders pay tax on them again.
Avoiding this taxation double whammy is a prime reason why stockholders elect S corporation status. However, there are certain limitations (e.g., the number of shareholders) for S corporations so be sure to understand how the restrictions affects your decision.
In an S corporation, the profits flow through to the shareholders via a K-1 form that is filed with their personal income taxes. The S election allows the corporate profits and losses to be treated somewhat similarly to the way a partnership is taxed. That is, at the individual’s rate, not the corporation’s.
Choosing the right entity to set up your business is a complicated decision because it has legal, tax and business ramifications. And laws vary between states, so be sure to check with your tax and legal advisors before making a decision.