There are several different forms a business can take. The business type determines which income tax return form you have to file, personal liability, applicable state filing regulations and other factors. Each different type of business has advantages and disadvantages. Choosing and setting up the right type of business for your operation can make life much easier down the road.
That said, it is not uncommon for a business to start out as a sole proprietorship and then adopt a different business type as the business expands. It is more difficult to dissolve partnership or LLC and revert to a sole proprietorship.
For any of these business types, if you choose to operate under a different name than the official name of the business entity, you will likely need to file a assumed name - also sometimes called a DBA (Doing Business As), trade name or ficticious name, with your state. See Using an Assumed Name for more details.
A sole proprietor is a person who owns an unincorporated business by him or herself. It is the simplest, most common and least expensive way to start a business - in fact, it is the "default" business type. If you start buying and selling under your own name, you have a sole proprietorship. With a sole proprietorship, there is no distinction between the business and the owner. The owner is entitled to all income and is responsible for all of the business’s debts, losses and liabilities.
For a sole proprietorship, the legal name of the business is your personal name. If you operate under a different name (i.e. your name is Suzie Q. Smith, but your business name is Suzie's Suds), you will need to file a Using an Assumed Name in your state.
Taxes for a Sole Proprietorship
For a sole proprietorship, all business income and expenses are filed on a Schedule C, attached the the business owner's personal tax return. Purchase and sale of business assets are filed on different forms, also connected to the owners personal tax return. Profit from a sole proprietorship is subject to self employment taxes. Depending on the amount of profit from the business activities, the owner may need to make quarterly estimated tax payments to cover income tax due on the profit.
Forming a Sole Proprietorship
Because a sole proprietorship is the default business type, no formal action needs to be taken to "go into business" as a sole proprietorship. If there is one owner, this status automatically comes from the owner’s business activities. However, as with all businesses, there are often state or local licenses or permits required; regulations vary by industry, state and locality. The Small Business Administration has a search tool to look up by zip code and see what licenses or permits you may need.
Advantages and Disadvantages of a Sole Proprietorship
- Easy and inexpensive to form. No action has to be taken to start, and there are no initial set-up fees other than getting proper state and local licenses.
- Complete control. There is only one owner, the sole proprietor, who has complete control over the business.
- Easy tax preparation. No additional tax return is required, just completion of a Schedule C (Business Profit and Loss) as an addition to the owners personal tax return.
- Unlimited personal liability. The person and the business are the same thing; there is no legal separation between the two. As a result, the owner is personally responsible for any debt or liability of the business.
- Potentially more difficult record-keeping. With a sole proprietorship it is much easier for the lines between business and personal income and expenses to become blurred. Without extreme dilligence, it may be difficult to accurately track how much profit (or loss) your business is actually incurring.
- Hard to raise money or investment. For a sole proprietors, raising money may be challenging; since you can't sell stock, investors may not want to invest. Banks may also be more hesitant to lend money to a sole proprietor without extensive personal guarantees.
A partnership is an agreement between two or more people to finance and operate a business. A Partnership is a legal entity that is separate from the partners themselves. In a general partnership, the profits, losses and certain line items flow through directly to the individual partners' tax return.
In a partnership, all the partners share, based on their percentage of ownership, in the profits or losses, each having contributed to the business in terms of money, property, labor and/or skill.
Because a partnership is involves more than one person, a partnership agreement is recommended. While not required, a partnership agreement that spells out how future decisions will be made can reduce or eliminate future issues in the management of the partnership or between the partners.
Typical items covered in a partnership include:
- The general goals or mission of the partnership
- Who will do what work and how it will be done.
- How will the business be financed.
- How profits or losses will be divided
- Dispute resolution processes
- If and how new partners may be brought in
- What will happen if one partner dies or becomes incapacitated.
- What happens if one or both partners want to dissolve the partnership.
Forming a Partnership
A partnership needs to be registered in the state in which it is formed. Registration is usually through the Secretary of State or the Dept. of Corporations. Usually all partners will need to sign the filing document; sometimes the partnership agreement is also requested or required.
The legal name of the partnership is the name given on the registration form, or the last names of the partners. If you operate under a different name (i.e. the legal name of the partnership is "Smith & Jones Big Soap Adventure", but you want your customers to know you as "SJ Soaps") the partnership will need to file a Using an Assumed Name in your state.
Taxes for a Partnership
Partnerships are required to file an IRS form 1065, partnership tax return. Part of that form includes Schedule K-1's, which are issued to each partner detailing their percentage of the income, expenses and other items with tax ramifications. Partners, even when they are working for or in the partnership, are not employees and should not receive W-2 forms. Instead, each individual partner takes the information from the K-1 and puts it into their own individual tax return, which is likely to impact the taxes owed by the partner. Partners may also be liable for self-employement taxes and/or need to file estimated tax payments to cover addition income tax due on profits from the partnership.
The partnership may need a tax professional to help with filing tax returns. Each partner in the partnership may also want to seek tax advice in order to prepare for any tax implications on his/her personal tax return.
Advantages and Disadvantages of a Partnership
- Easy to establish. It's pretty easy to establish a partnership; just file the required forms.
- Employee enticements. It may be easier to get employees if they see the possibility of becoming a partner in the future.
- Potential expansion. Provided it's been set out the partnership agreement, it can be relatively easy to bring in a new partner.
- Liability. In a partnership, partners are individually and jointly liable for the actions of the other partners, so you could potentially become liable for ALL the company's debts and liabilities (not just your percentage of them).
- Shared profit. A partnership means that there are more people to share the profit with.
- Limited life. A partnership is in existence as long as the partners agree to it. the partnership might be dissolved because a partner dies, a dispute between the partners, or just because one partner wants to move on to something else.
A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. The "owners" of an LLC are referred to as "members." Depending on the state, the members can consist of a single individual (one owner), two or more individuals, corporations or even other LLCs.
Forming a LLC
LLC's are formed at the state level, and there are some variations from state to state. In general, though, all that is needed is to decide on a business name, file the Articles of Organization (which may be called something different depending on the state) and pay any filing fee. The Department handling registration of LLC's is generally the Secretary or the Department of Corporations or something similar. Your operating agreement may also be required at the time of filing.
The LLC's Operating Agreement is the document that sets out all of the agreements between the members at the creation of the LLC. It is very similar to a Partnership Agreement or Corporate Bylaws in that it sets out how the business is to be run, who can be a member, how membership shares are transferred, what to do if there is a dispute between members or one member dies or wants to sell his/her shares, how to dissolve the corporation, etc. A well written and thought out operating agreement can potentially save substantial grief if there are problems down the road.
Taxes for a LLC
Unlike C-Corporations, an LLC is NOT taxed as a separate business entity. More like partnerships or S-Corporations the profits and losses are passed through to each member of the LLC. LLC members report profits and losses on their PERSONAL federal tax returns, just like the owners of a partnership would. The federal government does not tax income directly to the LLC, but some states do - so check with the appropriate state taxing agency.
Since the IRS doesn't recognize an LLC as a separate business entity, for taxation purposes the IRS treats LLC's as follows:
- One member. If there is only one member, the member reports the income and losses as a sole proprietorship (Schedule C of personal tax return)
- Two or more members. the LLC is treated as a partnership for tax retporting purposes (using Form 1065, with K-1's issued to members)
If the LLC wishes to be treated as a corporation, it must file Form 8832. In that case, with correct filing of forms and approvals, an LLC could be treated as a S-Corporation in the eyes of the IRS.
Advantages and Disadvantages of an LLC
Advantages of an LLC:
- Limited liability. As its title suggests, the LLC protects members from personal liability for business decisions or actions of the LLC. In other words, if the LLC incurs a liability, the members are usually not personally liable for the debt, which is similar to the protection afforded corporate shareholders. It is, however, a "limited" liability corporation, and members are not necessarily shielded from wrongful acts, including those of their employees.
- Less record-keeping. Compared to an S-Corporation, there is less paperwork and lower start-up costs, but you still get the same advantage of liability protection.
- Sharing of profits. There are fewer restrictions of sharing profit or loss with an LLC. Members may distribute profits as they see fit.
Disdvantages of an LLC:
- Limited Life. In some states, when a member leaves an LLC, the business is dissolved and the remaining members must close the business. They can then decide if they want to create a new business entity, or part ways. HOWEVER, you can provide provisions in the operating agreement concerning the transfer of membership shares on order to prolong the life of the LLC.
- Self employment taxes. Members of an LLC are considered self-employed and must pay self-employment taxes.
A corporation is a legal entity (recognized as a "person" in some circumstances) that is owned by shareholders. One of the most important aspects of this is that the corporation itself, not the individual shareholders, is held legally liable for the actions and debts of the corporation.
Corporations are typically more complex than other types of businesses and generally have higher administrative, legal and tax costs. With those issues, corporations are generally suggested for larger companies with multiple employees.
Forming a Corporation
The laws of the state in which the corporation is formed govern its formation. Generally, you need to decide on a business name, file Articles of Incorporation at the Secretary of State's office. Some states have additional requirements such as establishing directors, issuing stock certificates to the initial shareholders or requiring a copy of the bylaws. The legal name of the corporation is the one which is on the Articles of Incorporation. If you want to operate under a different name the corporation will need to file a Using an Assumed Name in your state.
The bylaws of the corporation constitutes the operating agreement and is the guiding document for the corporation. The corporate bylaws cover what the corporation does and how it operates. It may detail how board members are elected, the management structure of the organization, how shares may be purchased or sold, what to do on the death of a shareholder, etc.
Taxes for a Corporation
A corporation is taxed as a unique identity, and must pay federal state, and in some cases, local taxes. Corporations use IRS form 1120, corporate income tax return, to file their federal taxes. Unlike sole proprietorships and partnerships, corporate income is subject to double taxation in that corporations pay taxes on their income, and then the individual shareholders also pay personal income tax on any dividends (profit distributions) they receive from the corporation. Shareholders may be employees of the corporation and receive salaries or bonuses that are subject to personal income tax.
A corporation may elect to become a Sub-Chapter S Corporation (governed by sub-chapter S of the IRS code covering corporations). An S-Corporation differs from a regular corporation (usually called a C-Corporation) in that the corporate income, losses, deductions and credits are passed through to the shareholders and reported on the shareholders individual returns, reducing the possibility of double taxation on corporate income.
In order to be approved as an S-Corporation, the following requirements must be met:
- Be a domestic corporation
- Have only individuals, certain trusts and estates and shareholders AND not have any partnerships, corporations or non-resident aliens as shareholders
- Have 100 or fewer shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies and domestic international sales corporations)
Advantages and Disadvantages of an S-Corporation
As a full C-Corporation is not really business start-up option in most cases, only the advantages and disadvantages of an S-Corporation are discussed here.
Advantages of an S-Corporation:
- Tax savings. Corporate profit and loss are passed directly to the shareholders, avoiding double taxation. Tax returns are filed yearly (instead of quarterly, as required by a C-Corporation).
- Limited liability. Shareholders, directors, officers and employees have limited liability protection.
- Ease of transfer. An owner can transfer his or her ownership simply by selling his or her shares in the company.
- Perpetual existence. The business continues to exist as long as there are shareholders.
Disdvantages of an S-Corporation:
- Stricter operational processes. As a separate entity, Corporations (both S and C) require scheduled director and shareholder meetings, records of stock transfers and other administrative records.
- Closer IRS scrutiny. The IRS tends to watch payments to shareholders to determine whether the payment is salary or dividends (which are treated differently on your personal tax return).
- Formation and ongoing expenses. In order to be created as an S-Corporation, first a corporation must be created, and then the IRS must approve Sub-chapter S status. In some states, Sub-Chapter S status does not apply to state taxes, so corporate taxes may be due at a state level and other fees applicable to corporations (annual reporting fees, for example) may still be required.
Forming your business is one of the most important tasks to be accomplished from the outset. Choosing your business type should be carefully considered, looking at not only the current situation but where you envision your business will be in 2, 3, 5, or 15 years.
As you can see, there are advantages and disadvantages to each, but in the end it is a matter of legal formation and taxes. For example, if your goals are clear and you plan on growing enough to have employees, then being a sole proprietor may not be the best choice for you.
If you have the drive and ambition to bring in more than a little bit of income, consider the tax and liability ramifications of your business structure. Ideally, you want to find a balance between the cost of maintaining the business structure (both in actual costs and taxes and the time spent) with the tax benefits and liability protection you might receive.
Also consider speaking with a business attorney and/or tax professional for advice on what business type might work best for you in the short and long term.