When you start a business, you have thousands of decisions to make. One of the most important is how you will classify your business legally.
And while you’ve probably heard the terms floating around -- sole proprietorship, partnership, LLC, and corporation -- it’s crucial to understand the differences so you can choose the structure that works best for you. It will impact how much you pay in taxes, the liability you face, and your ability to raise money.
Here are a few thoughts I often share with my clients as they make decisions about their new business venture:
Sole Proprietorship
A sole proprietorship is the most common form of business organization. These businesses’ owners report business income and expenses on their personal tax returns and pay tax on any profit.
- ADVANTAGE: It's easy to form and gives the owner complete control of the business.
- DISADVANTAGE: The owner is personally liable for all financial obligations.
Partnerships
A partnership involves two or more people who agree to share in the profits or losses of a business.
- ADVANTAGE: Partners do not bear the tax burden of profits or the benefit of losses -- they are simply reported on partners’ individual income tax returns.
- DISADVANTAGE: Each partner is personally liable for the financial obligations of the business.
Corporations
A corporation is a legal entity created to conduct business. The corporation becomes separate from those who founded it. The corporation can be taxed, held legally liable for its actions, and make a profit.
- ADVANTAGE: Corporate status allows owners to avoid personal liability.
- DISADVANTAGE: The cost to form the corporation and the extensive record-keeping keeps many new business owners from pursuing this option. Setting up an S Corp or C Corp can sidestep some of the liability by allowing income or losses to be reported on individual tax returns (similar to a partnership).
Limited Liability Corporation (LLC)
An LLC is a hybrid form of partnership that’s growing in popularity.
- ADVANTAGE: Profits and losses can be passed to owners without taxation of the business itself, while owners are shielded from personal liability.
- DISADVANTAGE: Compared to a sole proprietorship or partnership, an LLC is a little more expensive to operate. Additionally, owners must keep personal business separate from the business of the company.
Now that you know a little bit about the different structures, here are a few questions to ask yourself when choosing one:
- To what extent do you need to be protected from legal liability? Consider whether your business lends itself to potential liability and, if so, if you can personally afford that risk.
- Based on your personal tax situation and business goals, where are your opportunities to minimize taxation? Keep in mind there are more tax options available to corporations than to proprietorships or partnerships.
- What funds do you have for setting up (and running) your chosen business structure? The tax advantages of a corporation may be nice, but they may not be enough to offset the costs of conducting business that way.
Note that no two business situations are the same--I’m happy to help guide you based on your personal circumstances. Feel free to give me a call or shoot me an email if I can be of any assistance.