When you start a new business, you have lots of decisions to make. From the name and location of your company to the products and services you offer, there are plenty of things to think about and plan. Don’t overlook your business structure in the process. How you define and organize your business is one of the most important decisions you make because it impacts your tax bill, personal liability, ability to raise money, and paperwork requirements, according to the Small Business Administration (SBA).
Depending on the type and size of your company, one or more business structure may be best for you. Here are the four most common, including their advantages and disadvantages.
Sole proprietorship is the most common structure and the easiest to form. Your business is automatically a sole proprietorship unless you structure it another way. In this business structure, the owner maintains control, making all of the decisions. The business is not considered a separate entity.
If you’re testing your concept, sole proprietorship is a good choice. It requires little to no paperwork, depending on your state’s licensing requirements. And it’s a good fit for low-risk businesses, such as consultants, virtual assistants or tutors.
Income and expenses are recorded on the owner’s personal tax return, using a Schedule C. If your business suffers a loss, which can be common in the beginning, it may offset income earned from other sources, reducing your tax bill. Another advantage, sole proprietor’s business earnings are taxed only once, unlike other business structures.
One of the downsides to this structure is that the owner is held liable for the business’s debts or obligations. If you’re sued or file bankruptcy, the court can seize your home and other assets to settle. Sole proprietors can have a hard time raising money because they cannot sell stocks. Banks are often hesitant to lend to sole proprietorships, which can mean you’ll have to tap into your savings or home equity or find optional sources of money.
If a business has two or more owners, a partnership can be a good structure, with two types: general and limited. A general partnership is similar to a sole proprietorship. Partners have equal control over the operation of the business, sharing in the profits, losses and liabilities. Income and expenses are recorded on the owners’ personal tax returns. While not required, a partnership agreement will set terms on how the business should be run, which can be helpful if one partner wants to sell or exit the business.
In a limited partnership structure, one or more of the partners will have limited decision-making authority while one or more of the partners will be considered general partners. Limited members are investors, and do not run or manage the business. It’s important to have a partnership agreement in place to distinguish the rights of each partner.
Like sole proprietorship, a partnership can be a good choice for businesses with multiple owners who want to test their idea. Also like sole proprietorship, the partnership isn’t directly taxed on its income, passing through any profits or losses to the individual partners.
A disadvantage to this structure is that general partners are personally liable for the business’s debts or obligations. In addition, each general partner can act on behalf of the business, incurring debt or making decisions that affect all of the partners. It’s important to think through scenarios and establish a strong partnership agreement to avoid disputes.
Limited liability company, or LLC, was created in 1977 and provides business owners with the liability protection that corporations enjoy without the double taxation. Similar to a sole proprietorship, profits and losses are filed through the owner’s personal tax return. However, the owners aren’t liable for the business’s debts or obligations, which protects your personal assets in case of a lawsuit or bankruptcy. As a result, it may be easier to get financing from a bank.
LLCs do have disadvantages. Tax treatment varies by state, so if you move you may need to restructure and find an accountant who is familiar with rules of the state. If you want to raise venture capital or investor money, LLCs aren’t ideal as you have no stock shares to offer.
Finally, a corporation is a legal entity separate from the founder and created to conduct business. It can be taxed and held liable in the case of bankruptcy or lawsuits, and it can make a profit. This structure has two main types: C Corp, which is a business owned by shareholders; and S Corp, which is more popular with small businesses.
The biggest advantage to forming this business structure is to avoid personal liability. Since a corporation’s debt and obligations are considered separate from the owner, it protects your personal assets. A corporation can also retain some of its profits, without the owner having to pay taxes on them. And a corporation business structure is better for raising money, as it can sell stock. This is a good structure for businesses that have higher risk of lawsuits, such as a daycare or restaurant, or that may eventually go public.
Corporations have disadvantages. The paperwork is complex and expensive to set up and requires an attorney. There are also extensive record-keeping requirements, and businesses must comply with more regulations. Also, owners of a corporation can be taxed twice if they take certain types of distributions, such as dividends — once on federal and state corporate income tax and again on their personal income tax return.
Choosing the right structure will provide you with guidelines that impact other business tasks, like taxes and licenses. Business laws can change, so consult an attorney or tax advisor who can provide personal insights on the best choice for you and your business. Once you cross this decision off of your list you can focus on the success of your business.
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