Step Two Choose A Business Structure
10 Steps to Starting A Business
Give some consideration to the business structure. The new business should balance the hassles involved with a particular entity with the benefits.
For many new businesses the best initial ownership structure is either a sole proprietorship or if more than one owner is involved a partnership. A sole proprietorship is a one person business that is not registered with the State. You don’t have to do anything special or file any papers to set up a sole proprietorship. You create one just by going into business for yourself. A potential draw back of the sole proprietorship is that it is inseparable from its owner. This means that the owner of the business reports business income and losses on his or her personal tax return and is personally liable for any business related obligations such as debts or court judgments.
Like a sole proprietorship a partnership is inseparable from its owners. A partnership is a business owned by two or more people that haven’t filed papers to become a corporation or a limited liability company. Sole proprietorships and partnerships make a lot of sense for small businesses where personal liability is not of great concern.
LIMITED PARTNERSHIPS (LP)
Limited partnerships are costly and complicated to set up and run and are not recommended for the average small business. Limited partnerships are usually created by one person who will solicit investments from others. The former party is known as the general partner and the latter is known as the limited partner.
The general partner controls the limited partnerships day to day operations and is personally liable for business debts. Limited partners have minimal control over daily business decisions. And in return they are not personally liable for business debts or claims.
CORPORATIONS AND LLCs
Forming and operating a LLC or a corporation is a little harder and costs more than a sole proprietorship or a partnership. But the added complexity and expense may be worth the trouble in some cases. The main benefit of an LLC or a corporation is that these business entities limit the owners personal liability for business debts and court judgments against the business. While this sounds great in theory in practice a very new business may not be able to limit the owner’s liability for business debts in the areas where it counts. Most banks will require a personal guarantee for instance. Similarly, most vendors will not offer credit to a new business entity. Instead, they will demand personal guarantees from the owner.
A corporation is an independent legal and tax entity separate from the people who own, control and manage it. Because of this separate status the owners of a corporation don’t use their personal tax returns to pay tax on corporate profits. The corporation is a legal entity which pays income taxes. This means that in theory there can be double taxation. Many small corporations pay out all of the corporate profit in the form of salaries and bonuses in order to have no profit left at the end of the year and avoid double taxation. (If your business is a corporation and you want to elect status as an S corporation (for special tax treatment), you need to file Form 2553, Election by a Small Business Corporation, available at www.irs.gov.)
Like corporations LLC provide limited personal liability for business debts and claims. LLCs are similar to partnerships when it comes to taxes. The owners of an LLC pay taxes on their share of the business income on their personal tax returns (it is possible for an LLC to be treated for tax purposes as a corporation and LLCs must pay the minimum franchise tax of $800 per annum just like corporations).
Corporations and LLC make sense for business owners who run the risk of being sued by customers or incurring a lot of business debts. Corporations and LLCs can also make sense for persons with substantial personal assets they wish to protect from business creditors.