Choosing The Right Business Structure

As a new business owner, deciding on the business entity or ownership structure of your business is one of the first major decisions you will need to make. Some of the factors you need to consider when making this decision are:

  • The potential risks and liabilities of your business.
  • Tax Issues.
  • Cost of establishing and maintaining your business entity.
  • Complexity of the business structure.

As with any major decision you will make as a business owner, it is important to investigate the various options, consider the advantages and disadvantages of each option, then make the decision that is right for your business. Your tax advisor and lawyer can assist you with making the right decision.

The main business entities are sole proprietorships, partnerships, corporations, and limited liability companies.

Sole Proprietorships

This business entity is simple and inexpensive to adopt. In a legal sense, the owner and the business are one and the same. A sole proprietor maintains complete control of the business, owning all the business assets as well as all profits. A sole proprietorship and its owner are considered to be a single entity for tax purposes, and the business proprietor reports profit or loss on his/her personal tax return (Form 1040: Individual Tax Return, Schedule C: Profit or Loss from Business).

This business structure has its disadvantages - Sole proprietors have unlimited personal liability on all debts and judgements relating to the business. Also, many sole proprietors find it more difficult to raise capital for their ventures.

Partnerships

This structure is also relatively easy to organize, and involves an agreement between two or more people who share the business. There should be a formal, legal agreement between the partners detailing the terms of the partnership, such as profit distribution, partner contributions, dispute resolution, changes to, or dissolution of the partnership.

Like a proprietorship, the business and its partners are a single entity. Partners report their share of profit or loss on their individual tax returns. Each partner is also jointly and personally liable for business debts, as well as the actions of the other partners.

There are two main types of partnerships:

General Partnership, where, unless stated otherwise in the partnership agreement, each general partner participates equally in the management and control of the business.

Limited Partnership - This business structure is usually used to attract investors as limited partners. Limited partners contribute capital, and share in the profits, but are not usually involved in the management of the business. The general partners manage the business and remain personally liable for business debts; limited partners incur no liability with respect to partnership obligations.

Corporations

Forming a corporation is more complex and expensive than the other business entities. A corporation is a separate legal and taxable entity, closely monitored by federal and state agencies.

The main advantage of forming a corporation is that the owners (shareholders) have limited personal liability for business debts or judgements against the corporation. In addition, corporations can sell stock to raise additional funds for the business.

Limited Liability Companies

This business structure is a fairly new business structure, and is also more complex and expensive to create than a partnership or sole proprietorship. As the name suggests, owners have limited personal liability for business debts and court judgements against he business.

LLC's may be formed with only one member, who may report business profits/losses on his/her personal tax return. An LLC with two or more members may be treated as a partnership for tax purposes, with each member reporting his/her share of the profits (or loss) on Form 1040. The LLC reports its profit or loss on Form 1064, confirming each member's profit or loss to the IRS.