Business Structures: Choosing What Your Business Will Look Like
One of the first steps to starting a new business is deciding how your business will be set up. If you are not planning on purchasing a previously established business or franchise, then the task of choosing the right structure is all the more important and daunting. Your decision will effect your tax status, will determine who has ownership in the business, and will delineate your personal liability should the business go into debt or close down.
In terms of business structure, there are basically three main categories: a sole proprietorship, a partnership, and a corporation:
Sole Proprietorship: A sole proprietorship is a business that is owned by a single person. It is the most simple form of business. With a sole proprietorship, the business owner assumes unlimited liability for all of the business’s debts. The business’ income or loss is also reported on the owner’s personal income tax return. Although establishing a sole proprietorship avoids the expense and hassle of forming either a partnership or a corporation, many business owners choose this option because they are unfamiliar with the other business structures.
Partnership: A partnership involves multiple owners of a single business and comes in two flavors: general and limited. In a general partnership, each co-owner assumes unlimited liability for the debts of the business. The business’ income and expense is reported on a separate tax return, but the co-owners additionally report their pro-rata share of the profit or loss from the business on their personal tax returns. With a limited partnership, each co-owner assumes unlimited liability for the debts of the business, but each owner is limited in liability to his or her individual contribution to the business. Tax reporting is generally the same as that for a general partnership with a few exceptions.
Corporation: A corporation is a separate legal entity that assumes responsibility for all its own expenses. This means that none of the shareholders in a corporation are held liable for the debts incurred by the corporation, and creditors are restricted to drawing from the corporation’s assets when seeking payment. The corporation also files its own tax return and pays taxes on its income, including the dividends that are distributed to its shareholders.
Aside from these three business structures, there are two “hybrid” entities. The first is known as an “S” Corporation, which is treated as a partnership in terms of tax payments, yet is considered a regular corporation in other areas. The second entity is known as a Limited Liability Company which provides limited liability for all of its members, but is generally treated as a partnership for federal income tax purposes.
For more information regarding the various business structures and their respective tax obligations, check out the IRS Website.