Understanding the Legal Business Entities

Among the many other decisions you'll have to make when starting your new business, you'll need to decide on your business' legal structure. Before you decide what business entity is best for you, consider the complexity of your business, the financial risk involved in running your type of business, and the tax consequences of each business structure. There is too much information to put into one article about the various business structures, but this is meant as a starter for those who are unfamiliar with the legal forms of business entities. Please do additional research by reading books, searching the web, or consulting a professional to help you choose the right structure for your business.


The Sole Proprietorship
The sole proprietorship is the simplest legal business structure. A sole proprietorship is an unincorporated business owned by one individual. You cannot form a sole proprietorship if you will have any other person going into business with you; you'll have to choose another business entity. It's relatively easy to set up business as a sole proprietor; you won't need to pay extra fees or hire a lawyer to set up shop as a sole proprietor. Many who do freelance work, work as an independent contractor, or those who turn a hobby into a weekend business work as a sole proprietor. A sole proprietor may work solo, or may choose to hire employees. If you have employees, be aware that you will be responsible for unemployment tax, social security and medicare tax, and income tax withholding for your workers.

Legally, the business and business owner are considered one and the same. The business will cease to exist if the owner dies; all business property will be treated as personal property, and passed on to their heirs or become part of their estate. A sole proprietor is not required to maintain a separate business bank account if they are simply doing work under their own name, and not as a fictitious business name. But, it may simplify your accounting to do so, especially if you have multiple sources of business income, or many business expenses. Income taxes are filed as an individual. The sole proprietor will need to file Schedule C and Schedule SE with their regular 1040 form, along with any other forms for estimated tax withholding or unemployment tax, if needed.

The downside to a sole proprietorship is that the business owner is personally liable for all business expenses, including taxes, debts, lawsuits, or any other expenses incurred by the business. That means that your personal assets, including your bank account, your car, and your home, are at risk if your business as a sole proprietor fails, incurs more expenses than income, or gets sued. This type of business entity can be a good choice if your business is fairly simple, will not be likely to incur much debt, and is not involved in risky work that could possibly result in a lawsuit. But, you may be better choosing another business structure if you fear that your business may incur liabilities beyond your control.


The Partnership
A partnership is an unincorporated business structure in which two or more people form a business together, whether by written contract or oral agreement. Each partner puts money, labor, skill, or property into the business, and each partner expects to share in the profits or losses of the business. Within the partnership structure, there can be a general partnership or limited partnership. A general partnership is one in which all partners are involved in running the business, and have unlimited liability for business expenses. The limited partnership consists of at least one general partner to run the business, and one or several limited partners, who are simply investors that are not involved in running the business. The limited partner will only be liable for the business' expenses up to the amount of their investment. You'll need to file a certificate of partnership with your Secretary of State to register your business name, but little else is usually needed to form a partnership other than your normal business licenses.

Partnerships must file an annual information return to the IRS, form 1065, to report business income and deductions, and profit and loss. If you have employees, the business is liable for unemployment tax, social security and medicare tax, and employee income tax withholding. But, the partnership, itself, is not taxed on income. Business profits are "passed through" to each partner, and each partner will have to report their share of business income or loss when they file their own individual tax return. In addition to the standard 1040 form, each partner will need to file Schedule E for income tax, and Schedule SE for self-employment tax. Partners in the business are self-employed, and not employees, so should not be given a W-2 form.


The Corporation
A corporation is a legal business entity that is separate from the owners of the business. This means the owner's liability is limited to their investment in the business, and they will not risk personal assets such as their home, car, and personal accounts. A corporation may be formed by one or many individuals. To form a corporation, you must file the documents required by your state, commonly called the articles of incorporation or a certificate of incorporation. State laws dictate how a corporation must be handled, since, by incorporating, the business can now sell shares of stock to investors.

The corporation consists of shareholders, directors, and officers. The owners in a corporation are shareholders, or members. The shareholders elect a director or board of directors, who will oversee the business and be responsible for the major decisions, but does not handle day-to-day operations of the business. The directors choose the officers, who will be responsible for daily business activities. Most states allow the positions of shareholder, director, and officer to all be held by one person. Corporations must adopt by-laws stating the way their business will be run, may issue stock, must have an initial meeting and annual stockholder meetings, and keep the minutes of those meetings with corporate records. It is possible to lose corporate status, and the protection that comes with it, if the company later fails to abide by the strict guidelines.

The profits of a standard corporation, also known as a C Corp, are taxed at the corporate level, separately from the members. Stockholders must also report any stock dividends as capital gains, and pay income tax to the IRS, which results in double taxation. Members who actively participate in running the business are considered employees of the corporation, can be paid hourly or by salary, will receive a W-2 for their employment income, and must pay individual income tax to the IRS according to their individual tax rate. There are no restrictions on the number of stockholders, or the country of residence of those stockholders. The C Corp may be owned by other business entities, and may issue multiple classes of stock.

The other type of corporation is an S Corp. An S Corp is a "pass-through" tax entity, where corporate profits or losses are passed to the member. The members must then report their share of the business' profit or loss on their individual tax returns, and pay tax at their individual rate. S Corps have many more restrictions than C Corps. S Corps may not have more than 100 shareholders, and all shareholders must be a U.S. resident. S Corps may only issue one type of stock. Also, an S Corp must be owned by a real, human, person; not a legal entity. This means they may not be owned by other corporations, business entities, or many trusts.


The Limited Liability Company (LLC)
The LLC is a fairly new business structure, recently allowed by state statute. An LLC offers owners, called members, the protection of limited liability for business expenses, like in a corporation. But, notice that it's called a Limited Liability Company, not Corporation. The LLC is not incorporated, meaning that it will not have to conform to the strict policies that is required of a corporation, such as electing corporate officials and having board meetings. The LLC also cannot publicly issue stock, but may accept money from private investors. On the other hand, the taxation of an LLC is treated like a partnership, passed through to the members. Each member must state their share of the business' profit or loss on their individual tax return.

Setting up and maintaining your business as an LLC is less complex than doing business as a corporation. You will need to file an article of organization with your Secretary of State, stating the names of the members of your LLC, as well as your business purpose and location. Most states do not put restrictions on who can own an LLC, meaning that it can be owned by individuals, corporations, partnerships, or other LLCs. Keep in mind that the fees and annual taxes for an LLC can vary widely by state. The big attraction to an LLC is that it can give business owners the safety of a corporation, while leaving out the complications and management requirements of incorporation. This allows business owners the flexibility to manage their business how they see fit, and has quickly become a popular business structure for small businesses.


Sources:
irs.gov
nolo.com
bizfilings.com