The business structure that you choose affects everything from how your earning will be taxed to how much personal liability you have, when something goes wrong with your business. If you choose the wrong structure for your business you could not only end up paying more of your hard earned money away in taxes, but could also be putting your personal assets like your home at risk.
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Here are the primary factors to consider when choosing a business structure.
- Personal liability
- Tax consequences
- Ease of setup
- Partnership Issues
Sole proprietorship:
Sole proprietorship is the easiest structure of the business. Even you don’t even have to do anything to set it up. If you have given that a product or service to the public, do not have any partners, and have not setup any other legal entity for the business, then you are involuntarily a sole proprietorship.
You are personally liable for any mistakes debts etc. that are incurred by the business. If you are selling arts and crafts online then this may not be a big deal. If on the other hand your business involves taking on the lot of debt or removing large trees from beside people’s houses, then this likely a large issue.
With the sole proprietorship you pay all taxes on all earning of the business, revenues minus expenses, and cannot pay a portion of the money over and above your salary out as a distribution, which is generally tax in a lower rate. You pay a similar income tax rate on money from your sole partnership as you would pay had the money come from an employer.
This is the easiest business to setup. No paperwork required setup as a sole proprietorship. If you want to business under a different name from your own will need a business as from or otherwise DBA which can learn more about on the SBA’s website.
You will generally not be able to raise money from outside investors as a sole proprietorship. Sole proprietors do not have partners. The equivalent of sole proprietorship with partners is a general partnership.
For business that have no partners and do not have the potential for large legal and financial liability starting as a sole proprietorship may not be bad option. However, once the business starts to grow you are likely going to want to change to one of the other entities.
General Partnership:
A general partnership is a very basic business structure, if two more partners agree to do business with each other. And do not set up another type of business structure, and then they are automatically a general partnership with no official paperwork required. There is no distinction between business and personal.
This is an even more important point with general partnerships, because you are liable for your partner along with yourself. Such as, if one of them goes out and runs up a lot of debt for the business sued then you are liable as well.
There is no paperwork required to set up as a general partnership, unless you want to do business under a different name in which case you need to file a doing business as form with your state. Although not required it is highly recommended to put together a partnership agreement for general partnerships.
You will generally not be able to raise money from outside investors as a general partnership. Unless you have a partnership agreement in place to the contrary, any partner may decide to dissolve the partnership, and the partnership automatically dissolves should one of the partners declare bankruptcy.
Because of the additional liability and potential disputes that arise under a general partnership. It is not recommended as operating as general partnership. If you do not have the funds currently to setup as one of the other business structures below, then at a minimum make sure you setup a partnership agreement.
Limited Liability Company:
A limited liability company separates the individual and the business from the liability standpoint, and provides lot flexibility in how the business is run and taxed. It is therefore generally the first entity that should be considered when setting up a business structure. In this way LOC act like a corporation. After setting up an LOC, if no election is made with the IRS, then income from the LOC will pass through to the owners in the same manner it does with a sole proprietorship and general partnership. However, LOC’s can also elect to be treated as C-Corp or S-Corp from a tax standpoint.
You will have to file paperwork with your state to set up an LOC. However, there are many online services that can help you do so and it is not very burdensome. Along with state filling fees it should generally be less than $500.
Choosing an LOC will likely not prevent you from raising money, unless you are those who are investing in planning to take the company public. Most states allow what is known as a single member LOC so you generally do not have to have a partner in order to setup an LOC. Unlike a general partnership LOC’s are seen as the separate entity from the partners and can therefore continue to operate, should one of the partners decide to leave the business.
Like with general partners however, there should be well-crafted partnership agreement, which is called as operating agreement LOC structure executed between the partners to outline how the business will be run and how any issues will be handled.
LOC’s offers the best of worlds, liability protection and the flexibility to choose how you like to be treated from a tax standpoint. They also require less paperwork and maintenance than a C-corporation. For these reasons they should generally be the first option considered when seeking a legal entity that provides liability protection.
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