Visit the Business Credit Center to learn how you can successfully obtain and build credit.
Determining your business's legal structure
Familiarize yourself with the organization, liability, and tax implications of four common business structures.
Along with fine-tuning your business plan, securing funding, and attracting customers, deciding the type of business entity you will run is essential to starting a business.
The structure you choose impacts your personal liability, tax filing, and ability to attract investors and other owners. Before you pursue the necessary licenses and permits, consider seeking the advice of your accountant or tax advisor.
Here's a breakdown of four common legal structures for a business.
1. A sole proprietorship
The sole proprietor is an unincorporated company run by an individual. This is the simplest structure to create, because you need not take any formal action to form a sole proprietorship.
When it comes to liability for financial debts or legal obligations of the business, there's no distinction between the business and the owner. The owner is personally liable.
Similarly, when it comes to filing taxes, the business's income is considered the business owner's income. As a sole proprietor you would need to fill out a Schedule C on your personal federal tax return.
2. A partnership
In a partnership, two or more people or entities share ownership of a business. In a general partnership, partners share the risk, profits, and losses of the business. That's why it is important to choose partners carefully and have a written partnership agreement. In a limited partnership, there are both limited and general partners, and the limited partners' liability is generally limited to their capital contributions, unless they sign a separate guaranty of the partnership's obligation.
On the positive side, partnerships leverage multiple skills and divide up the work — many successful businesses started out as partnerships. Each partner pays his or her portion of any taxes on individual tax returns. The partnership itself files an "information return" with the IRS.
3. A corporation
A corporation is a legal entity owned by one or more shareholders, and it files its own tax return. It's often called a C Corporation for tax purposes.
A C corporation is sometimes said to have a tax disadvantage for a small business owner known as "double taxation." Profits are taxed once at the corporation level and again at the level of the shareholder-owner who receives the business earnings.
An S corporation is a special type of corporation that "elects" a specific treatment for federal tax purposes. It's a corporation with a limited number of shareholders and limited individual liability. However, S corporation shareholders avoid double taxation on business earnings. Profits are "passed through" for tax purposes to the owner(s) on their individual federal tax returns, without the S corporation paying income tax on the distribution. Please note: State tax laws vary from state to state, and not all states extend the "pass through" tax treatment to S corporations.
The IRS limits the number of shareholders in an S corporation to 100, and requires that shareholders be U.S. citizens. Certain strict recordkeeping obligations must also be met.
In general, a corporation provides liability protection for shareholders. The corporation is legally liable for the actions and debts of the business, not the individual shareholders. A corporation is also advantageous if you plan to bring on investors or give employees an ownership stake, as you can grant them ownership in the form of stock shares.
4. A limited liability company
Today the LLC is one of the most popular structures for small businesses. Instead of shareholders, one or more "members" owns the business. Similar to a corporation, members of an LLC are generally personally protected from the business's debts and legal actions unless they sign a separate guaranty.
LLC members generally report business profits and losses on their personal federal tax returns. The business itself is not required to pay income taxes on its profits, but if you're a single-member LLC, you can choose to be taxed as a corporation.
Each business structure has advantages and disadvantages. Consult your tax advisor or your CPA, as well as your lawyer, early in the business lifecycle. He or she can evaluate all the ramifications and how they will affect your individual situation to make sure you are on the right track.