The options for starting a business with any state aren’t endless, but they are plentiful. There are varying options to review when starting a business. Before choosing an option, it’s best for a business owner to consider a few key parameters so they will know what the best business entity they should use is.
Some of the parameters to consider when starting a new business are how the business will be taxed or how many owners will it have. Here are more questions to get an idea of the best business type to start:
- Will the owners need liability protection?
- Will the owners like double taxation?
- Will the business need access to investment capital?
- Does the business owner value managerial control?
- Is limiting administrative and record retention cost important?
There are 5 different entity types a business can be set up as.
The sole proprietorship is among the most common entity types. This entity has a single owner and does not require a lot of annual paperwork to maintain. Many freelancers are running sole proprietorships. The owner of a sole proprietorship, also referred to as a sole proprietor, owns and operates the business without any investment from any other individual or business.
What makes this entity type stand out from others is the unlimited exposure to liability on the part of the sole proprietor. The sole proprietor bears personal responsibility for any liability that results from the business. Those who are in business performing services will be wise not to operate as a sole proprietor. Any faults that arise from their service can be detrimental to them personally.
Sole proprietorships have a straight-forward tax structure. The earnings from the business are taxed once a year on the owner’s individual federal tax returns. This taxation structure is considered a benefit to the business owner because it can help them reduce their overall tax liability in some situations.
A partnership is an entity that organizes two or more owners together in a joint venture. The owners are called partners. There are two types of partnerships: a general partnership and a limited partnership. In a general partnership, all partners share equal responsibility for the business, its debt and profits. In a limited partnership, the limited partners are each limited to the amount of liability, debt, and profits they share in the partnership. A limited partnership will also have general partner(s). The general partner(s) own and operate the business and their liability is not limited. Limited partners in a limited partnership will act like silent partners in most cases.
The drawbacks for a limited partnership are the number of administrative duties that are required. Limited partners’ limitations are outlined in a well-drawn out operating agreement. This can be daunting if a lot of limited partners are involved.
Partnerships are taxed similar to sole proprietorships. Partners file their share of profits on their individual tax returns.
The corporation is information-intensive and complex. Filing a corporation requires more administrative duties than any other entity. The corporation has a very different tax structure and also offers more tax advantages than any other entity structure. The corporation is also considered a separate entity from its owners. The downside to this is double taxation, where investors, also known as owners, pay taxes on their investment dividends as well as taxes on the business revenues. A business owner can opt for the “S Corporation” entity, which is a type of corporation that allows pass-through taxation, much like a partnership. This is a way for a corporation owner to avoid double taxation.
The corporation is the best choice for a business owner who wishes to expand in the future or become a publically traded company. This is done through shareholders. A corporation can offer shareholders access to ownership as it needs to raise capital. This requires strong accounting records and a strong management team. Investors will only be interested in a corporation whose profits are sustainable.
Business owners who are savvy enough to understand the many benefits that come with corporations, such as corporate tax loopholes and expansion potential, will benefit greatly from a corporation structure. They should weigh the pros and cons of the drawbacks and consider if they are worth it.
Limited Liability Corporation
The Limited Liability Corporation, most commonly referred to as the LLC, is a hybrid type of corporation that gives the best of both partnerships and corporations. The limited liability company is different from the LLP, limited liability partnership, in that the limited members of a limited liability company are able to fully participate in the operation of the LLC. They all still enjoy the benefits of limited liability protection under the law.
In addition, the members will not be double-taxed, which is very similar to the S corporation. Limited liability company members will file the business taxes on their individual income taxes.
There are two types of limited liability company formations. There is the multi-member limited liability company and there is the single-member limited liability company. The single-member limited liability company operates very much like a sole proprietor. In fact, it is recognized as a sole propriety by the IRS for tax purposes. The single-member limited liability company still gets to enjoy the benefits of limited liability protection in most situations. A multi-member limited liability company will be taxed similar to the S corporation. Each member will pay taxes on the revenue earned in the limited liability company on their individual tax returns.
Business owners should consider that the corporation is the only entity that can have a forever shelf-life. This is because it’s a separate entity from the owners. The sole proprietorship, partnership, and limited liability company will all dissolve at the death of at least one of the owners.