Choosing the appropriate structure for your business entity is the culmination of a balance of competing interests; most often weighing a business owner’s exposure to liability against the magnitude of the entity’s structure and reporting requirements. For example, a sole proprietorship balances minimal formal structure and organizational cost (arguably enormous advantages) against unlimited personal liability (a significant risk/disadvantage).
In contrast, a corporation (including both a standard and an S corporation) and a limited liability company are more highly regulated but provide limited liability or legal responsibility in that a shareholder’s liability is limited to the amount of his or her investment. Additional entity structures include partnerships and cooperatives.
In all instances, there are nuances to each approach, frequently in the areas: ownership size restrictions (regarding the number of owners); ease of transferability of interests; and taxation (e.g., whether income and losses “flow-through” to individual partners or shareholders). As a result, structuring an entity should always involve expert legal and accounting advice to facilitate formation, avoid immediate (often costly) pitfalls, and to allow for the organization’s future adaptation to the needs of the business.
The materials below are intended to assist in the process of choosing the appropriate entity structure for your business.
Business Structures - Home Business
As described by the Internal Revenue Service (IRS):
"When beginning a business, you must decide what form of business entity to establish. Your form of business determines which income tax return form you have to file. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute. Legal and tax considerations enter into selecting a business structure."
Business Structure Descriptions
The U.S. Small Business Administration provides a brief description of each type of business structure identified by the IRS:
The sole proprietorship is a simple, informal structure that is inexpensive to form; it is usually owned by a single person or a marital community. The owner operates the business, is personally liable for all business debts, can freely transfer all or part of the business, and can report profit or loss on personal income tax returns.
Limited Liability Company (LLC)
The LLC is generally considered advantageous for small businesses because it combines the limited personal liability feature of a corporation with the tax advantages of a partnership and sole proprietorship. Profits and losses can be passed through the company to its members or the LLC can elect to be taxed like a corporation. LLCs do not have stock and are not required to observe corporate formalities. Owners are called members, and the LLC is managed by these members or by appointed managers.
Partnerships are inexpensive to form; they require an agreement between two or more individuals or entities to jointly own and operate a business. Profit, loss, and managerial duties are shared among the partners, and each partner is personally liable for partnership debts. Partnerships do not pay taxes, but must file an informational return; individual partners report their share of profits and losses on their personal return. Short-term partnerships are also known as joint ventures.
C Corporation (Inc. or Ltd.)
This is a complex business structure with more startup costs than many other forms. A corporation is a legal entity separate from its owners, who own shares of stock in the company. Corporations can be created for profit or nonprofit purposes and may be subject to increased licensing fees and government regulation than other structures. Profits are taxed both at the corporate level and again when distributed to shareholders. Shareholders are not personally liable for corporate obligations unless corporate formalities have not been observed; such formalities provide evidence that the corporation is a separate legal entity from its shareholders. Failure to do so may open the shareholders to liability of the corporation's debts. Corporate formalities include: (1) issuing stock certificates; (2) holding annual meetings; (3) recording the minutes of the meetings; and (4) electing directors or ratifying the status of existing directors. Corporations should always be assisted by a qualified attorney.
Sub Chapter S Corporation (Inc. or Ltd.)
This structure is identical to the C Corporation in many ways, but offers avoidance of double taxation. If a corporation qualifies for S status with the IRS, it is taxed like a partnership; the corporation is not taxed, but the income flows through to shareholders who report the income on their individual returns.
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