When you plan to start a new business, one of the most critical matters is choosing the legal structure. We refer to this as the forms of business organization.
You have multiple options on the table, including limited liability, sole proprietorship, partnerships, versus corporations. Every format offers distinct features, such as different taxation methods and varying degrees of personal financial liability. Therefore, consulting a tax professional and an attorney will make things easier to understand.
Every form of business organization requires different documents and requisites to be submitted to the associated Secretary of State’s Office.
Types of Business Entities
It is the most basic and most straightforward structure to run an enterprise. A sole proprietorship is an unincorporated form of business organization where the owner and the business are legally classified as one.
The owner is entitled to all the gains, debts, liabilities, losses, incurred by the company. Being a sole proprietor, you do not need to take any formal action to start your operation.
As long as no one else is involved, your business activities will fall under sole proprietorship. You may already be engaging in such business activities, but you are not aware of it. For example, a freelance writer is a sole proprietor.
However, it is a legal requirement for a sole proprietor to obtain permits or licenses to start operations just like any other business. The regulations or policies are different in different industries; they are also dependent on locality and state. You can find the listings of local, state, or federal permits, registrations, and licenses by querying the appropriate agency.
You may have to file for a fictitious name if you do not want to use your name to start your business as a sole proprietor. However, the name you choose must be original (you cannot use a name utilized by another firm).
A sole proprietorship does not fall under separate taxation. That said, the business owner and the company are classified as one. Additionally, the income from the operation will be regarded as the income of the owner.
A sole proprietor follows Schedule C and standard form 1040 to report the business income, losses, profits, and expenses. The “bottom line amount” obtained from schedule C is transferred to the owner’s income taxes.
The owner is responsible for withholding or paying all income taxes, including self-employment taxes and estimated taxes. If you want to know more about the sole proprietorship taxes and other requisites, you can visit IRS.gov.
LLC (Limited Liability Company)
LLC is a Limited Liability Company abbreviated.
LLC is different from sole proprietorship because it is a distinct legal identity and is separate from its owners.
That said, the company’s owner(s) are not personally responsible (generally) for the lawsuits or debts of the company.
This feature differentiates this business format from other structures such as sole proprietorship, general partnerships, and corporations.
LLC can be of two types, single-member LLC (owned by one person) or multiple members LLC (owned by more than one person).
These are hybrid business styles that offer combined benefits of a sole proprietorship, partnership, and corporation such as asset protection and flow-through taxation.
Inc. is a short form of “incorporation.” If the word “incorporation” is attached to a company’s name, it means the company is legally registered (incorporated) in at least one state.
It means the company’s founders have completed all paperwork, satisfied all fees, and the state government views it as a legal incorporation.
Corp. is a short form of “corporation.” If the word “corporation” is attached to a company’s name, it means that the company is registered (incorporated) in one state, at least.
Corporations are distinct from LLCs in that they are held (or owned) by the shareholders. A “general corporation” – with a corporate ending of Corp., Inc., Ltd., or Co. – appoints officers and directors to manage day-to-day operations. At the same time, LLCs have members to carry out those functions.
It is a type of corporation where the corporation’s shareholders pass all the finances, including income, credits, deductions, and losses.
The shareholders of the corporation are taxed separately for the revenue or losses sustained from the corporation.
However, the corporation is not subjected to double taxation. Of course, this is just a snippet of the S Corp; understanding it in greater detail requires you to perform your due diligence.
Just like C Corp and S Corp, people often relate “Benefit Corporation” to B Corp and use B Corp as a short form of Benefit Corporation, but these are different entities.
A Benefit Corporation is a form of a legal business model similar to S Corp or C Corp. Apart from earning profits, a Benefit Corporation is also responsible for contributing towards the well-being or welfare of the community. Some states have made it compulsory for Benefit Corporations to provide proof of activities related to the public interest.
Just like C Corp, Benefit Corporations are subjected to double taxation. On the other hand, B Corp is more of a certification from B Lab, which is a global non-profit organization. A company that is a certified B Corp means that it has fulfilled the transparency standards set by the B Lab, and the company delivers what it claims.
Any “for-profit company” can earn the status of B Corporation by meeting the criteria. Moreover, B Lab has made it mandatory for all B Corporations to become Benefit Corporations if their respective states allow them to be.
C Corp or C Corporation represents the word “Corporation.” The word “C” says that the corporation’s income is taxed under the Internal Revenue Code’s subchapter C. These corporations are subjected to double taxation, which is covered by this law.
Although C Corporation is the most common entity model in the United States, it may not be a suitable or recommended startup option. Corporations are separate legal business entities, and they are taxed separately from their owners.
Moreover, corporations can file lawsuits in their name, and others can file lawsuits against corporations. Its income, profit, losses, and expenses are separate from its owners. It provides the highest level of protection (from personal liability) to its owners.
A general partnership is a basic form of partnership business model. It is designated as a contract involving at least two persons where they have a legal agreement of sharing income, losses, expenses, liabilities, assets, and other elements of a business.
Partners involved in general partnership do not have any liability protection. i.e., they are responsible for the liabilities of their company. One partner can be held accountable for the partnership-related acts of other partners.
If one partner commits a fraud, the client (victim) can sue the other partner(s), and the state can forfeit their personal properties to the extent of their liability.
A general partnership requires at least two people who agree to be responsible for each other’s actions related to the business. A partnership deed or agreement can be oral, but creating a written agreement signed by all partners is always safe.
Most importantly, a general partnership is not taxed separately. The loss or profit earned by the partners is added in their “personal” incomes, respectively, and taxed accordingly.
A limited partnership is a category of partnership business models in which there are two types of partners, including general partners and limited partners. To make a limited partnership, at least one partner must have limited liability, and one must have general liability.
In a limited partnership, general partners are liable for the business. Furthermore, any company or a person can assume the role of general partner. Generally speaking, people set up LLCs to act as a general partner for a limited partnership; this allows people to avoid personal liability. Moreover, general partners share the responsibility of conducting the business.
On the other hand, limited partners are not personally liable for business matters. Limited partners cannot intervene in the regular business operations as the law strictly prohibits them. If a limited partner is found guilty of prohibited matters, his/her limited liability protection can be revoked.
The taxation method is different for LPs – as there is no double taxation for them.
General partners are legally obligated to pay self-enrollment tax, and the limited partners get their dividends, and those dividends are added to their “personal” income.
Limited Liability Partnership
It is a category of partnership business model in which the partners’ liability is limited to business purposes. That said, LLP partners cannot be personally liable if an external party sues the partnership.
There must be at least two partners to make an LLP, and all partners can participate in regular business activities.
Moreover, a double taxation system does not apply to LLP as dividends are added to all the partners’ “personal” incomes. However, in some cases, LLPs may have to pay state franchise taxes.
How do you choose the right type of business?
Choosing your startup’s best option can be a tricky process, but it is not an impossible task. There are three main factors that you must consider before deciding, and they are:
Each of the various forms of business organization has been wholly discussed in this guide, which can help you choose the right one for your objectives.
If your pocket permits it, hiring an attorney for these matters is always the best option. Remember, the form of business organization you choose will have a crucial impact on your future business.