One of the earliest decisions every small-business owner must make is how to set up the company. Although it’s not as exciting as selecting a name for the business or approving a logo, choosing a structure for your business has important legal and tax implications down the road. Here are the four most common options available to you.
A sole proprietorship is the simplest business structure possible. A sole proprietor is essentially an entrepreneur who flies solo, someone who owns and operates a company alone. That owner is entitled to all of the profits and bears all of the responsibility for debts, losses, and liabilities related to the business.
There is no formal process or paperwork for becoming a sole proprietor. It often happens organically in the development phase of a new venture. In the eyes of the IRS, the sole proprietor and the business are really one and the same: The business isn’t taxed separately, and income from it is reported on the business owner’s personal Form 1040. The IRS also expects sole proprietors to withhold appropriate income taxes and pay quarterly estimated taxes.
Two or more people may form a partnership to share ownership of a business. The partners benefit equally from the profits of the business, and they share in the decision-making as well as the liability.
To be legally recognized as a partnership, the company usually must be registered in its home state, and the partners must obtain proper permits, licenses, and a tax identification number. The partnership itself isn’t taxed; the profits and losses are passed to the partners, who record them on their individual tax returns.
The parties involved in a partnership may choose to operate under a legal agreement that spells out their responsibilities, how disagreements will be handled, and steps for ending the partnership, if necessary.
A corporation is a more complex structure for a business than a sole proprietorship or a partnership. It is a legal entity that is owned by shareholders. The corporation is legally liable for the actions and debts of the business.
The corporation structure is generally used by larger businesses with multiple employees. Rules for setting up a corporation vary from state to state, but they usually involve registering the corporation with the IRS, state government, and local revenue agencies. The founders also must obtain the proper licenses and permits.
Limited Liability Company
A limited liability company, or LLC, blends the features of partnerships and corporations. As with a partnership, profits and losses flow from the company to the members of the LLC to be reported on their individual federal tax returns. Some states, however, do tax income from an LLC.
An LLC gives its members limited liability against lawsuits or debts involving the company, so that their personal finances are usually not at risk because of business decisions. (An LLC doesn’t protect its members if a business decision was made with wrongful intent.)
LLCs must be registered under the rules of the state in which they are located. This enables them to file the proper documents for registering the company name, its articles of incorporation, and an operations agreement and for obtaining proper licenses and permits.