Choosing the right business entity structure may seem like any easy step in setting up a new business, but the wrong choice can be very costly. Each form of business structure has its own advantages and disadvantages, and each has its own rules and requirements. Choosing the right one is an important choice based upon the particular operation and goals of each individual business.
The five major business forms are sole proprietorship, general partnership, limited partnership, limited liability company, and corporation, which may then be classified as either a “C-Corp.” or an “S-Corp.”
- Sole Proprietorship – This is the default business form of any single person doing business who has not taken steps to set up any formal business structure. A sole proprietor is personally responsible for all debts and liabilities of the business. Income is taxed directly to the individual owner on his or her personal income tax return. A sole proprietor may operate under a trade name other his or her own name, often called a “dba” which stands for “doing business as.”
- General Partnership – This is the default business form of any business consisting of more than one person, which has not taken steps to set up any formal business structure. Each individual partner is personally responsible for the debts and liabilities of the partnership, even if it was incurred by a fellow partner without his or her consent. Income is taxed to the individual partners’ income tax return in proportion to their ownership interest in the partnership. General partnerships often operate under a Partnership Agreement, which sets forth the rights and responsibilities between the partners.
- Limited Partnerships – Unlike general partnerships, limited partnerships are created by filing Articles of Formation with the local Secretary of State’s Office. Limited partnerships are operated by one or more general partners, with one or more limited partners who are essentially passive investors. The general partners are responsible for all of the debts and liabilities of the limited partnerships. In contrast, the limited partners are only responsible for business debts and liabilities up to the value of their interest in the limited partnership. As a tradeoff, limited partners have no say in how the business is run by the general partners. Limited Partnerships are governed a Limited Partnership Agreement. Like a general partnership, income is taxed to the individual partners in proportion to the ownership interest in the limited partnership.
- Limited Liability Corporation – An LLC is the newest and most flexible form of the major business structures. LLC’s are created by filing Articles of Formation and are governed by an LLC Operating Agreement. The owners of an LLC are called members, and like the name implies, the members’ liability for business debts is limited to the value of their ownership interest in the LLC. The individual members are not personally liable for the acts of their fellow members like general partners would be. LLC’s may be operated by one or more managers, who may or may not be members of the LLC. LLC’s may be taxed as a “pass-through” entity, meaning income passes through the LLC to the individual owners like a partnership, or the LLC may be taxed on the entity level like a corporation. LLC’s must file business tax returns, annual reports and other requirements.
- Corporation – A corporation is the oldest and most popular of the formal business structures. It is created by filing Articles of Incorporation with the Secretary of State and is governed by its By-Laws. Liability of the shareholders is limited to the value of the stock that they own in the corporation. Corporations may be privately held or publicly traded on national and international stock exchanges. Corporations may be classified for tax purposes as either a “C-Corp.” or an “S-Corp.” All corporations are automatically considered to be a C-Corp. unless they elect to be treated as an S-Corp. under Subchapter S of the Internal Revenue Code (hence the name). There are restrictions in the Code that sets forth which corporations qualify for S-Corp. treatment. A qualifying S-Corp. will be taxed as a “pass-through” entity like a partnership. A standard C-Corp. on the other hand will be taxed first on the corporate entity level, then again on the personal level for any distributions received by the individual shareholders. Corporations must file business tax returns, annual reports and other requirements.
For a free half hour consultation about which business structure may be right for you, contact Attorney Christopher E. Ratté.
NOTICE: The information and articles posted on this website are for informational purposes only and are not intended as legal advice. Contact me to discuss your particular situation or consult a licensed attorney in your state.
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One of the biggest problems I’ve found is that many business owners will simply select the LLC approach, and assume they’re done, not realizing that they have made a taxable entity decision to be a sole proprietor or general partnership.
I’ve generally found that most attorneys prefer the LLC, since legally, you can’t really go wrong there. From a tax perspective, our preferred tax entity is for the LLC to elect to be taxed as an S Corporation.
From a legal perspective, there is very little difference between an LLC and an S-Corp. They both essentially achieve the same liability protection, and the structures, although different, are mostly a matter of terminology in my opinion. A business owner should always choose the entity that best accomplishes their overall tax and financial strategy. Thanks for your comment, Steve.