Have the Best Business Structure for Your Startup?
How you structure your company is a critical decision. Here are the pros and cons of five common choices.
Of all the choices you make when starting a business, one of themost important is the type of legal structure you select for yourcompany. Not only will this decision have an impact on how much youpay in taxes, it will affect the amount of paperwork your businessis required to do, the personal liability you face and your abilityto raise money.
The simplest structure is the sole proprietorship, which usuallyinvolves just one individual who owns and operates theenterprise.
Advantages: The expenses and your income from thebusiness are included on your personal income tax return, meaningbusiness losses you suffer may offset the income you've earnedfrom other sources.
Disadvantages: You're personally responsible for yourcompany's liabilities. Raising money for a sole proprietorshipcan also be difficult. Banks and other financing sources are oftenreluctant to make business loans to sole proprietorships.
If your business will be owned and operated by severalindividuals, look at structuring your business as a partnership.Partnerships come in two varieties: general partnerships andlimited partnerships. In a general partnership, the partners managethe company and assume responsibility for the partnership'sdebts and other obligations. A limited partnership has both generaland limited partners. The general partners own and operate thebusiness and assume liability for the partnership, while thelimited partners serve as investors only; they have no control overthe company and aren't subject to the same liabilities as thegeneral partners.
Advantages: A partnership doesn't pay taxes on itsincome but "passes through" any profits or losses to theindividual partners. At tax time, each partner files a Schedule K-1form, which indicates his or her share of partnership income,deductions and tax credits.
Disadvantages: Personal liability is a major concern.Like sole proprietors, general partners are personally liable forthe partnership's obligations and debts. Each general partnercan act on behalf of the partnership, take out loans, and makedecisions that will affect and be binding on all the partners (ifthe partnership agreement permits). Partnerships are also moreexpensive to establish than sole proprietorships because theyrequire more legal and accounting services.
A corporation is an independent legal entity, separate from itsowners, and as such, it requires compliance with more regulationsand tax requirements.
Advantages: A corporation's debt isn't consideredthat of its owners, so you're not putting your personal assetsat risk. A corporation can also retain some of its profits withoutthe owner paying taxes on them. Another plus is the ability of acorporation to raise money. A corporation can sell stock, eithercommon or preferred, to raise funds. Corporations also continueindefinitely, even if one of the shareholders dies, sells theirshares or becomes disabled.
Disadvantages: There are higher costs involved.Corporations are formed under the laws of each state, each of whichhas its own set of regulations. You'll probably need theassistance of an attorney and accountant to guide you. And not onlyare corporations subject to corporate income taxes at both thefederal and state levels, any earnings distributed to shareholdersin the form of dividends are taxed at individual tax rates on theowners' personal income tax returns.
The S corporation has some appealing tax benefits but stillprovides business owners with the liability protection of acorporation.
Advantages: With an S corporation, income and losses arepassed through to shareholders and included on their individual taxreturns.
Disadvantages: S corporations are subject to many of thesame requirements corporations must follow, and that means higherlegal and tax service costs. They also must file articles ofincorporation, hold directors and shareholders meetings, keepcorporate minutes, and allow shareholders to vote on majorcorporate decisions. The legal and accounting costs of setting upan S corporation are also similar to those for a standardcorporation.
Limited Liability Company
Limited liability companies, often referred to as"Lacs," are hybrid entities, bringing together some ofthe best features of partnerships and corporations. "An LLC isa much better entity for tax purposes than any other entity,"says Ralph Anderson, a CPA and small-business tax specialist withaccounting firm M.R. Weiser.
Advantages: LLCs were created to provide business ownerswith the liability protection that corporations enjoy without thedouble taxation. Earnings and losses pass through to the owners andare included on their personal tax returns.
Disadvantages: The tax treatment for LLCs varies bystate. If you plan to operate in several states, you must determinehow a state will treat an LLC formed in another state. If youdecide on an LLC structure, be sure to use the services of anexperienced accountant who is familiar with the various rules andregulations of LLCs.
Excerpted from Start Your Own Business: The Only Start-UpBook You'll Ever Need (Entrepreneur Media Inc.).