Business Legal Structures 101

19 04 2010

Choosing the legal structure of your business is not only important, it’s crucial to determining how you operate your business. The legal entity you choose will affect how much personal liability you face, how much you pay in taxes and how in-depth your new company’s record keeping will need to be. It’s basically the bare bones structure of your business – you need it in order to execute your vision.

Hopefully, if you feel like you’re at a fork in the road, this post may lend some clarity. The following list includes the eight basic business entity types:

  1. Sole Proprietorship;
  2. Partnership;
  3. Limited Partnership;
  4. Limited Liability Company (LLC);
  5. Corporation (for-profit);
  6. S Corporation;
  7. Nonprofit Corporation (not-for-profit); and
  8. Cooperative.

The best entity for you will depend on the type of business you want to run, your potential exposure to lawsuits, the number of owners and whether you want the ability to raise capital or transfer shares. It’s smart, and in many cases necessary, to consult a lawyer or accountant when making your choice.

Based on several great resources that I referenced at the base of this post, I’ve listed below the characteristics, advantages, and disadvantages of each entity below, including the relevant tax related information.

Sole Proprietorships and Partnerships:

For many new businesses, the best initial ownership structure is either a sole proprietorship or — if more than one owner is involved — a partnership.

Sole proprietorships and partnerships make sense in a business where personal liability isn’t a big worry — for example, a small service business in which you are unlikely to be sued and for which you won’t be borrowing much money for inventory or other costs.

Sole Proprietorships

A sole proprietorship is a one-person business that is not registered with the state like a limited liability company (LLC) or corporation. You don’t have to do anything special or file any papers to set up a sole proprietorship — you create one just by going into business for yourself.

Legally, a sole proprietorship is inseparable from its owner — the business and the owner are one and the same. This means the owner of the business reports business income and losses on his or her personal tax return and is personally liable for any business-related obligations, such as debts or court judgments.

Advantages of a Sole Proprietorship:

  • Easiest and least expensive form of ownership to organize.
  • Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.
  • Sole proprietors receive all income generated by the business to keep or reinvest.
  • Profits from the business flow directly to the owner’s personal tax return.
  • The business is easy to dissolve, if desired.

Disadvantages of a Sole Proprietorship:

  • Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
  • May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.
  • May have a hard time attracting high-caliber employees or those that are motivated by the opportunity to own a part of the business.
  • Some employee benefits such as owner’s medical insurance premiums are not directly deductible from business income (only partially deductible as an adjustment to income).

Federal Tax Forms for Sole Proprietorship: (only a partial list and some may not apply)

  • Form 1040: Individual Income Tax Return
  • Schedule C: Profit or Loss from Business (or Schedule C-EZ)
  • Schedule SE: Self-Employment Tax
  • Form 1040-ES: Estimated Tax for Individuals
  • Form 4562: Depreciation and Amortization
  • Form 8829: Expenses for Business Use of your Home
  • Employment Tax Forms

For partnerships and the remaining business entities, read below.

Partnerships

Similarly, a partnership is simply a business owned by two or more people that hasn’t filed papers to become a corporation or a limited liability company (LLC). You don’t have to file any paperwork to form a partnership — the arrangement begins as soon as you start a business with another person. As in a sole proprietorship, the partnership’s owners pay taxes on their shares of the business income on their personal tax returns and they are each personally liable for the entire amount of any business debts and claims.

Advantages of a Partnership

  • Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement.
  • With more than one owner, the ability to raise funds may be increased.
  • The profits from the business flow directly through to the partners’ personal tax returns.
  • Prospective employees may be attracted to the business if given the incentive to become a partner.
  • The business usually will benefit from partners who have complementary skills.
  • Disadvantages of a Partnership
  • Partners are jointly and individually liable for the actions of the other partners.
  • Profits must be shared with others.
  • Since decisions are shared, disagreements can occur.
  • Some employee benefits are not deductible from business income on tax returns.
  • The partnership may have a limited life; it may end upon the withdrawal or death of a partner.

Types of Partnerships that should be considered:

  • General Partnership
    Partners divide responsibility for management and liability as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
  • Limited Partnership and Partnership with limited liability
    Limited means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short-term projects or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.
  • Joint Venture
    Acts like a general partnership, but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such as well as distribute accumulated partnership assets upon dissolution of the entity.

Federal Tax Forms for Partnerships: (only a partial list and some may not apply)

  • Form 1065: Partnership Return of Income
  • Form 1065 K-1: Partner’s Share of Income, Credit, Deductions
  • Form 4562: Depreciation
  • Form 1040: Individual Income Tax Return
  • Schedule E: Supplemental Income and Loss
  • Schedule SE: Self-Employment Tax
  • Form 1040-ES: Estimated Tax for Individuals
  • Employment Tax Forms

Limited Partnerships:

Limited partnerships are costly and complicated to set up and run, and are not recommended for the average small business owner. Limited partnerships are usually created by one person or company (the “general partner”), who will solicit investments from others (the “limited partners”).

The general partner controls the limited partnership’s day-to-day operations and is personally liable for business debts (unless the general partner is a corporation or an LLC). Limited partners have minimal control over daily business decisions or operations and, in return, they are not personally liable for business debts or claims. Consult a limited partnership expert if you’re interested in creating this type of business.

Corporations and LLCs:

Forming and operating an LLC or a corporation is a bit more complicated and costly, but well worth the trouble for some small businesses. The main benefit of an LLC or a corporation is that these structures limit the owners’ personal liability for business debts and court judgments against the business.

Corporations and LLCs make sense for business owners who either (1) run a risk of being sued by customers or of piling up a lot of business debts, or (2) have substantial personal assets they want to protect from business creditors.

Corporations

What sets the corporation apart from all other types of businesses is that a corporation is an independent legal and tax entity, separate from the people who own, control and manage it. Because of this separate status, the owners of a corporation don’t use their personal tax returns to pay tax on corporate profits — the corporation itself pays these taxes. Owners pay personal income tax only on money they draw from the corporation in the form of salaries, bonuses, and the like.

Advantages of a Corporation:

  • Shareholders have limited liability for the corporation’s debts or judgments against the corporations.
  • Generally, shareholders can only be held accountable for their investment in stock of the company. (Note however, that officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.)
  • Corporations can raise additional funds through the sale of stock.
  • A corporation may deduct the cost of benefits it provides to officers and employees.
  • Can elect S corporation status if certain requirements are met. This election enables company to be taxed similar to a partnership.

Disadvantages of a Corporation:

  • The process of incorporation requires more time and money than other forms of organization.
  • Corporations are monitored by federal, state and some local agencies, and as a result may have more paperwork to comply with regulations.
  • Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible from business income; thus it can be taxed twice.

Federal Tax Forms for Regular or “C” Corporations: (only a partial list and some may not apply)

  • Form 1120 or 1120-A: Corporation Income Tax Return
  • Form 1120-W Estimated Tax for Corporation
  • Form 8109-B Deposit Coupon
  • Form 4625 Depreciation
  • Employment Tax Forms

LLCs

Like corporations, LLCs provide limited personal liability for business debts and claims. But when it comes to taxes, LLCs are more like partnerships: the owners of an LLC pay taxes on their shares of the business income on their personal tax returns. The owners are members, and the duration of the LLC is usually determined when the organization papers are filed. The time limit can be continued, if desired, by a vote of the members at the time of expiration. LLCs must not have more than two of the four characteristics that define corporations: Limited liability to the extent of assets, continuity of life, centralization of management, and free transferability of ownership interests.

Federal Tax Forms for LLC:

  • Taxed as partnership in most cases; corporation forms must be used if there are more than 2 of the 4 corporate characteristics, as described above.

S Corporations:

A tax election only; this election enables the shareholder to treat the earnings and profits as distributions and have them pass through directly to their personal tax return. The catch here is that the shareholder, if working for the company, and if there is a profit, must pay him/herself wages, and must meet standards of “reasonable compensation”. This can vary by geographical region as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit. If you do not do this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for all of the payroll taxes on the total amount.

Federal Tax Forms for Subchapter S Corporations: (only a partial list and some may not apply)

  • Form 1120S: Income Tax Return for S Corporation
  • 1120S K-1: Shareholder’s Share of Income, Credit, Deductions
  • Form 4625 Depreciation
  • Employment Tax Forms
  • Form 1040: Individual Income Tax Return
  • Schedule E: Supplemental Income and Loss
  • Schedule SE: Self-Employment Tax
  • Form 1040-ES: Estimated Tax for Individuals
  • Other forms as needed for capital gains, sale of assets, alternative minimum tax, etc.

Nonprofit Corporations:

A nonprofit corporation is a corporation formed to carry out a charitable, educational, religious, literary, or scientific purpose. A nonprofit can raise much-needed funds by soliciting public and private grant money and donations from individuals and companies. The federal and state governments do not generally tax nonprofit corporations on money they take in that is related to their nonprofit purpose, because of the benefits they contribute to society.

Cooperatives:

Some people dream of forming a business of true equals — an organization owned and operated democratically by its members. These grassroots business organizers often refer to their businesses as a “group,” “collective,” or “co-op” — but these are often informal rather than legal labels. For example, a consumer co-op could be formed to run a food store, a bookstore, or any other retail business. Or a workers’ co-op could be created to manufacture and sell arts and crafts. Most states do have specific laws dealing with the set-up of cooperatives, and in some states you can file paperwork with the secretary of state’s office to have your cooperative formally recognized by the state. Check with your secretary of state’s office for more information.

References:

I would be remiss if I didn’t direct you to the references that helped me write this post. The parent sites of each article are also great business resources as well.

Photo courtesy of Leo Reynolds.

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3 responses

20 04 2010
Anna

Regarding LLCs, under Treasury Regulation 301.7701-2, the corporate characteristics classification method is no longer used. It is now governed by the “check-the-box” regulations located at 301.7701. Thus, as default, a single-member LLC is taxed as a disregarded entity and a multi-member LLC is taxed as a partnership unless the entity elects to be taxed as a C corporation.

20 04 2010
thecompanyline

Thanks for your clarification Anna!

23 04 2010
Small Business Resources in Washington. « The Company Line: BLOG

[…] Business Legal Structures 101 – Choosing the legal structure of your business is not only important, it’s crucial to determining how you operate your business. […]

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