The business structure you choose will affect the amount of taxes you pay, how you can raise capital (i.e. shareholders and sale of stock), the legal paperwork you need to file, your personal exposure to risk, and the regulations you must follow.
There are four common types of business entities: sole proprietorship, partnership, corporation, and limited liability company (LLC). The best structure will afford you optimal legal protection and financial benefits.
To determine the ideal legal structure for your business, start by reviewing the basics of each type below:
A sole proprietorship is the easiest structure to form as you do not have to register your name or business with the state. Once you commence business activities, you are considered a sole proprietorship.
In a sole proprietorship the company and individual, or married couple acting as a single unit, are considered one and the same, meaning the owner’s personal assets are the company’s assets. This setup carries the highest risk regarding your personal finances and legal responsibility, as you are held personally liable for all business debts and doings.
Sole proprietorships are not taxed as a separate entity such as with corporations. Instead, the sole proprietor is subject to both income tax and a self-employment tax, or contributions to Social Security and Medicare.
A partnership is nothing more than an agreement among two or more people to share responsibility for running a business. The share of personal liability carried by each partner depends on the specific partnership structure, of which there are two common types: limited partnerships (LP) and limited liability partnerships (LLP).
Limited partnerships typically have one or more general partners who carry unlimited liability and one or more limited partners who have limited liability. Personal liability is generally tied to the partner’s involvement in operations and managerial decisions and/or financial investment. The extent of a partner’s control is usually documented in a partnership agreement.
Though the IRS requires partnerships to submit an annual information return to report income, deductions, gains, losses, and other operation-related finances, profits are reported on the partners’ personal income tax return. General partners must also pay self-employment taxes.
Limited liability partnerships (LLP) are slightly different. All partners or owners are equally protected from liability, meaning they are not responsible for the debts of the company or the independent decisions of individual partners.
In California, LLP structures are limited to specific professional practices types, including architects, engineers, land surveyors, lawyers, and accountants.
Corporations are more complex and costlier to form, though the structure affords the highest degree of protection to owners from personal liability. Unlike sole proprietorships and partnerships, corporations are considered a separate legal entity, much like a person; hence they can profit, pay taxes, and be held legally liable.
Ownership is determined via stock, therefore the shareholders make the business decisions and stakes can be transferred relatively easily, avoiding the complications of dissolution upon an owner’s death or exit.
The government generally levies an income tax on corporate profits and imposes personal income taxes on dividends paid to shareholders. A special corporation classification called an S corporation may help qualifying entities avoid double taxation, instead taxing only dividends.
Limited Liability Company (LLC)
Limited liability companies (LLC) balance the tax advantages of a partnership with the limited liability of a corporation. As with a corporation, an owner’s personal assets, such as savings or a home, are shielded from risk in the event of a lawsuit or bankruptcy. As with a partnership, however, members must pay personal income taxes on profits in addition to self-employment taxes.
Because choosing a business structure affects more than just day-to-day operations, consulting a qualified business attorney can help you avoid future legal consequences. For professional guidance, please contact our attorneys at Norman Dowler, LLP. We will focus on the law so that you can focus on growing your business.