Sept 2, 2018
Three types of legal structures exist for doing business in the United States. A sole proprietorship is the easiest to set up and if a person is conducting business they are automatically considered a sole proprietorship in absence of any type of business registration. Two or more persons conducting business can form a partnership and the third type is a corporation, a legal structure that is a completely separate entity from the persons conducting business.
A sole proprietorship is a fairly common option for persons wanting to start a small business. Under this legal structure, a proprietor is the sole owner and responsible for all financial and legal aspects of the business. Most small businesses are managed as a sole proprietorship. This can be a benefit in that no one else can intercede or interfere in the running of your business. It is fairly inexpensive to set up and doesn’t require a lot of complicated legal paperwork. The business is also not taxed separately; all expenses and liabilities of the business are ‘pass-through’ and show up on the owner’s personal tax return. A sole proprietorship does not have to be in the owner’s name, it can be a fictitious business name; but all legal requirements need to be followed (usually by filing a fictitious DBA statement with the county clerk).
Some of the drawbacks, which can give a new business owner pause, is the fact that they are personally responsible for all debts and liabilities incurred by the business. Another drawback is the relative inability to attract investors. Funding of a small business is usually only available through a small business loan (secured by the owner’s assets) or the owner uses his own personal capital or assets. Another is the very reason many small businesses start out as sole owners – no one else shoulders the management decisions and responsibilities. However, over time, as the business takes over your life both inside and outside of the office this can often become a very significant liability. You may find it very draining to have no one else emotionally invested in the business, having no one to discuss business decisions with or no one to take over when you need to take time away.
A partnership is another type of legal business structure that is similar to a sole proprietorship except it is used when there are multiple owners. There is a larger cost in setting up a partnership, as hiring a lawyer and drawing up a partnership agreement is strongly encouraged.. A partnership agreement is a legal document that defines each owners’ rights and responsibilities including the daily running of the business, how the profits/losses will be split, and how the company can be dissolved or what the rights of survivorship are if one of them dies. It is also designed to identify numerous contingencies that can help to avoid costly litigation in the event of partner disagreements, which are inevitable at some point.
A primary advantage of a partnership is similar to a sole proprietorship, in that the profits or losses are passed through to each partner’s personal tax return. One disadvantage of partnerships is they each have personal liability for the management and financial obligations. Other disadvantages include the requirement for more complicated business/legal paperwork, mismanagement or other malfeasance on the part of one partner can affect the running of the business and/or all partners and partnershipps tend to be difficult to dissolve.
There are three types of partnerships: general partnership (GP), limited partnerships (LP) and limited liability partnerships (LLP). Limited partnerships have only one general partner who is responsible for the business and all other partners have limited liability. The partners with limited liability also have limited control over the company, which is documented in the partnership agreement. Profits are passed through to personal tax returns, and the general partner also pays self-employment taxes.
An advantage of a general partnership is the low cost of setup – there are little or no business filings required. A disadvantage of a general partnership is general partners have no protection from the business losses, mismanagement or other actions.
A limited partnership has one general partner with unlimited liability for the business, and one or more limited partners. Limited partners are only liability to the extent they invested in the business and cannot be held responsible for the business debts. They also do not participate in the day to day management of the business.
Limited liability partnerships are similar to limited partnerships, but give limited liability to all partners. With an LLP each partner is responsible for their debt, not the debt or misconduct of the other partner(s).
A corporation is a third type of business structure and it differs from sole proprietorships and partnerships in that it is a legal entity that is separate and distinct from its owners. Corporations legally have the same rights and responsibilities as a person, they can borrow money, own assets and pay taxes. Corporations are usually formed by registering with the state and a lawyer is normally involved in setting up a corporation. There are two kinds of corporations: for profit or non-profit.
Two types of for profit corporations are the S Corporation and C Corporation. Both are distinct legal entities created under state law. They enable business owners to separate themselves, legally and financially, from the business itself. There are numerous requirements that require compliance (issuance of stock, hold regular shareholder meetings with recorded minutes, assets cannot comingle with shareholders personal assets etc.) in order for a corporation to maintain a separate legal status and shareholder protection can be lost if they are not followed.
One of the main advantages of corporations is that owners can sell their shares of the corporation, without impacting the management of the business and if one of the shareholders dies the corporation ‘lives’ on. Most small companies are generally set up as S Corporations. Larger companies are usually set up as C Corporations. One disadvantage of a C corporation is the way its profits are taxed. A C corporation’s income is taxed, and then the profits pass to the shareholders as dividends, which are then taxed again. This is known as double taxation. S corporations pay shareholders a salary out of the profits and the remaining profit is distributed to them at the end of the year and isn’t subject to self-employment tax.
A Nonprofit corporation is a second type of corporation that is organized for specific tax-exempt purposes. To qualify for nonprofit status, your corporation must be formed to benefit: (1) the public, (2) a specific group of individuals, or (3) the membership of the Nonprofit.