When setting up your business, you will need to establish your company under one of many business structures. The business structure you choose will influence everything. From your day-to-day operations and taxes to how much of your personal assets are at risk and everything in between, it's important to consider structures with a reasonable balance of legal protections and benefits.
Let's take a closer look at sole proprietorships, partnerships, limited liability companies, S corporations and C corporations so that you understand your options as well as the differences between these five types of business structures.
A sole proprietorship gives you complete and utter control over your business. However, your business assets and liabilities will not be separate from your personal assets and liabilities, meaning you can be held personally liable for the business's debt as well as any other relevant financial obligations.
With a sole proprietorship, it can be hard to raise money because you will not be able to sell stock in your company. Similarly, banks hesitate to lend money to sole proprietorships given the nature of this type of business structure. However, sole proprietorships are a low-risk business type that lets you test your business idea before reestablishing your company as another type of business.
A partnership is a very simple business structure designed for situations in which two or more people plan to own a business together. The two common types of partnerships are limited partnerships and limited liability partnerships. LPs are structured in such a way that there is only one general partner who has unlimited liability and that person must pay self-employment taxes.
Furthermore, partners with limited liability have what is known as limited control, which should be documented within the partnership agreement. Profits are passed via personal tax returns.
On the other hand, LLPs extend limited liability to every single owner, not just one. So each partner is protected from debt that the partnership is responsible for and no partner will be held responsible for actions taken by the other partners.
Limited liability company
An LLC is a business structure that makes it possible for you to take advantage of the benefits of both a corporation and a partnership. However, it's important to keep in mind that each state has its own regulations that must be followed.
Even so, in general, you should be protected from personal liability, meaning your vehicle, house, property or personal savings will not be at risk of being taken from you should a bankruptcy or lawsuit arise.
Instead, profits and losses are passed along and become part of your personal income without the attachment of corporate taxes. All owners are considered to be self-employed and, as such, each of them must pay self-employment tax as their way of contributing to Medicare and Social Security.
An S corporation is a type of business structure that helps business owners avoid double taxation, which allows for profits and certain losses to be passed directly to owners as part of their personal income without being taxed under corporate tax rates. S corps must file with the IRS to be regarded as having status as an S corp.
But again, the specifics of an S corporation will vary from one state to the next. Some states tax S corps on any and all profits they accrue beyond a certain limit, while other states do not recognize the S corp election as a business structure at all, choosing to regard them as C corporations instead.
That said, the IRS imposes limitations on which entities can be considered S corps. For example, businesses that seek to establish themselves as S corporations cannot have more than 100 shareholders and the shareholders can only encompass individuals and certain trusts and estates.
A C corporation is a type of legal entity that is separate from its owners. While C corps can make a profit, be taxed and be held legally liable, they offer the strongest protection from personal liability out of all the business structures.
C corps must pay income tax on the profits they yield and may face double taxation, meaning they could be taxed upon making a profit and taxed when dividends are distributed to all shareholders. The biggest advantage of establishing your business as a C corp is that you will be legally able to sell stock to the public. That said, the rules for running a C corp are extraordinarily complex and you should think about this business structure considerably before deciding to establish your company as such.
At the end of the day, the business structure you select for your company will affect your tax rates, management protocols and paperwork requirements, as well as whether fundraising is a possibility. Choosing the right business structure from the start is among the most crucial decisions you can make as a business owner.
If you are unsure as to which option is best for you, prioritize working closely with financial and legal experts who can help you make the right choice.
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