When starting a business it’s important to understand and select the most appropriate business structure for your company. The business structure is the entity which owns your business and the structure of that entity can affect how profits flow to the owner(s) of the business, how liability is applied to the owners, and finally how the company pays taxes.
In the United States, for any enterprise there are three basic business structures that can be used – sole proprietor, partnership, or corporation. A sole proprietor is generally a small operation with one or more people who are involved in the business. For tax purposes, the sole proprietor (being the “sole” owner) files an income statement under Schedule C on the personal 1040 form. Any profit from the business is included as direct income to the sole proprietor and these profits are also subject to self-employment taxes as well.
In terms of liability, anything for which the sole proprietorship is liable for, the person owning the business is liable as well. This means that all of a person’s assets are at risk when operating as a sole proprietor as whatever debts are incurred by the business are required to be paid by the business owner. This structure may be perfectly fine in some situations where liability is not factor and self-employment taxes may be eliminated if the proprietor already pays the maximum amount somewhere else.
A partnership has two or more people who share in the ownership of a single business. Like a sole proprietorship, the law does not distinguish between the business and its owners. This means that the partnership needs to have a legal document which outlines how decisions will be made, how the profits are divided, how disputes are resolved, and how members are added to the partnership or can be bought out. Partnerships also need to decide up front how the partnership may be dissolved when necessary.
Partnerships can be created under three different types – a general partnership, a limited liability partnership, and a joint venture. A general partnership is where the partners divide responsibility for management and liability as well as shares of the profits or losses as outlined in the partnership agreement. Unless there is a written agreement, then equal shares amongst the partners is assumed.
A limited liability partnership is one in which most of the partners have limited liability (equal to that of their investment in the partnership) as well as limited influence regarding management decisions.
A joint venture is similar to a general partnership except it applies for a limited period of time or a single project.
A corporation, on the other hand, is chartered by the state in which it is headquartered and is considered by law to be a unique entity which is separate and apart from those who own it. A corporation may be taxed, or sued, and can also enter into contractual agreements. The owners of the corporation are its shareholders.
Corporations come in three different forms – the common corporation is the “C” corporation where taxes on the profits are paid by the corporation apart from taxes paid by the individuals. An “S” corporation, other the other hand, is a corporation which changes the tax election status of the company. In this situation, the profits flow from the company directly to the owners’ personal income tax and are therefore taxed only once – at the personal level and under the personal tax schedules.
A new entity is the limited liability corporation (LLC) which is a hybrid structure which provides limited liability to the owners but operates much like a partnership.