A necessary step in the initial stages of setting up your new business is to determine which form of business ownership structure to adopt. The ownership structure that may prove to be most appropriate will depend on circumstances such as:
- how many owners there are (ownership sharing)
- the type of product you will be producing
- the number of employees you will have working for you
- the extent of protection desired in order to protect both the business and the ownership at the personal level from any liability losses
This article provides a brief overview of what structures are available and the pros and cons of each. The most popular structures in use are as follows.
- Sole Proprietorship
- Partnership
- Corporations (C-Corps)
- LLCs
- S – Corps
- Nonprofit Corporations
Sole Proprietorship
A sole proprietorship is the simplest structure. There are no documents to file or fees to pay, and this is in stark contrast to what is required to form LLCs and corporations. You are the sole owner of your business, and you must simply begin business operations to commence a sole proprietorship.
It’s important, however, to be aware of your personal liabilities in this structure. As Small Business notes: “in terms of the legal entities involved in a sole proprietorship, you and the sole proprietorship are the same thing. This means that you will pay taxes on any business profit as income on your personal taxes, and if your business has any liabilities (like a court judgment or a past due debt), you are personally liable for them.”
Partnership
According to the IRS, a partnership is defined as a relationship existing between two or more parties who join to carry on a trade or business. Each party contributes money, property, labor or skill, and expects to share in the profits and losses of the business. A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return. Partners are not employees and should not be issued a Form W-2.
Corporations (C-Corps)
In forming a corporation--as explained by the IRS--prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally does the following things:
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It takes the same deductions as a sole proprietorship to figure its taxable income.
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It can also take special deductions.
For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders. The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax, and this means two things:
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the corporation does not get a tax deduction when it distributes dividends to shareholders
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Shareholders cannot deduct any loss of the corporation
LLCs
Perhaps the main reason you would want to organize your business as an LLC is to shield yourself from any personal liability that may arise from your business' dealings.
As Small Business notes, “an LLC, just like a corporation, provides limited liability to the owners of the LLC for the business' liabilities, including debts, judgments and others.”
Taxes, however, differentiate an LLC from a corporation. An LLC is not a separate tax entity, and ownership of the LLC are required to pay personal income taxes on any share of profits they receive during the tax year in question.
As SmallBusiness.com emphasizes, organizing your business as a LLC makes sense in two situations:
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If the business is engaged in a dangerous activity that makes it more likely to be sued, or if the business has the potential of racking up large amounts of debt, then a corporation or a LLC may be a good idea to shield the owners from personal liability.
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If any of the owners of a business have large amounts of personal assets that they want to shield from any potential liability associated with the business, a corporate or an LLC could be the best option.
S Corporations
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
The IRS says the following about S corporation reporting:
Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
A corporation must meet the following additional requirements to qualify for S corporation status:
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Be a domestic corporation
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Have only allowable shareholders
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May not be partnerships, corporations or nonresident alien shareholders
Nonprofit Corporations
As the legal site NOLO states in regards to nonprofits and why a nonprofit is formed: “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.”
In general, the federal and state governments do not tax nonprofits on any money taken in that is related to their organization’s mission to benefit society.