One big question every business owner needs to answer when starting a company is what type of entity to form: a sole proprietorship, corporation, limited liability company or something else entirely? To make the best decision, it helps to understand what each of these terms means:
Sole Proprietorships – Operated by one individual, a sole proprietorship is easy and inexpensive to set up and doesn’t have to keep as many records for the various governmental agencies when compared to other types of businesses. Sole proprietors control the company’s finances and profits by themselves, which also makes taxes easier as they’re simply included on their personal income tax forms. Unfortunately this also means the sole proprietor is personally liable for the business’ debts and the IRS can declare the company a hobby rather than a business, which has negative tax consequences. Sole proprietors often have more trouble raising startup capital than other entities as well.
Corporations – With a separate legal identity from the owner, corporations can be very large or very small. Because it’s a separate entity, it provides the owners with protection from legal liability. Corporations can also issue stock, which is a strong selling point to potential investors. The downsides? Corporations can be more expensive and time consuming to form due to paperwork and filing fees. The law also requires them to observe various formalities to make sure they operate as separate entities, independent from the owners, and profits have the potential to be double-taxed.
Partnerships – In a partnership, two or more individuals share the risk and benefits of the business entity. Like a sole proprietorship, the partnership is taxed on the owners’ tax returns, with the partnership filing only an informational tax return. Partnerships also tend to be simpler and easier to form, providing more flexibility than corporations or other types of entities. The main disadvantage of this type of business is liability; both partners are personally liable for the other individual’s debts incurred in furtherance of the partnership. This makes it harder to raise money from investors as well.
Limited Partnerships – In this type of business entity, there’s at least one general partner and at least one limited partner. The general partner(s) have most of the power and manage the day-to-day operations; they’re also personally liable for 100% of the company. The limited partner(s) cannot participate in the day-to-day management and are protected from the general partners’ debts. They do receive a share of the profits as well. This is a great option for the passive investor who has a level of trust with the general partner.
LLPs (Limited Liability Partnerships) – Similar to general partnerships, LLPs need to have at least two people involved. Unlike general partnerships, each partner in an LLP is protected from the other partners’ actions. Additional features of LLPs include less structure (they don’t need a board of directors, for example), the business isn’t liable for taxes (the partners are each individually responsible for them) and the partners have certain rights to the income and profits without being liable for the companies debts. In general, states usually limit LLPs to professionals like lawyers and accountants if they recognize it as a company at all.
LLCs (Limited Liability Companies) – As a combination of a general partnership and corporation, LLC owners (called members) have extremely limited liability for the company’s debts. In addition to additional legal protection, the pros to this type of entity include various tax benefits, unlimited members and less mandatory paperwork than corporations require. The cons include the necessity of converting to a corporation before going public, needing to follow different tax rules and some states blocking certain professions (like construction contractors, architects or accountants) from becoming an LLC.
Want to know more about these types of business entities? We can provide additional specifics and make recommendations based on your situation. Contact us to find out more!
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