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It's possible that you haven't really given too much thought about the tax and legal ramifications of the legal ENTITY you have chosen for your business. After all, it's hardly something to worry about when you're just starting out. Once your business begins to get off the ground, you do need to turn your mind to such things.
Each state, province, and country is DIFFERENT and you will need to take the advice of your own professional lawyer or accountant before making a final decision that's right for you. For this reason, this article should not be used as a substitute for independent professional advice.
This most simple form of business entity is ONE person who is the sole owner of the business. You are required to file a FICTITIOUS business name if your surname does not appear in the name of your business or the name of your business suggests the existence of other owners. The business does not have an existence SEPARATE and independent from its owner. This may be a good choice for you if you don't use agents or employees -- and where personal liability for business debts is not a major concern. When your business starts to grow, it may be time to consider another form of entity for your business.
A sole proprietorship is SIMPLE and inexpensive to set up -- you've probably done it without even realizing just by getting business cards printed. The owner reports the business's profit and loss on his or her PERSONAL income tax return -- the business doesn't have to file a separate tax return. The owner may offset a business loss against other income. And the owner has total management and CONTROL of the business.
The owner has personal, unlimited LIABILITY for the debts of the business. The owner may find it difficult to obtain financing. Community property is at risk if the owner is married and the owner is personally liable for the acts and omissions of agents and employees.
A partnership is a business with two or more owners where each partner SHARES in the management of the business and in the liability for the acts of fellow partners. The internal workings are governed by a partnership AGREEMENT which should include:
A partnership is relatively simple and inexpensive to set up. Each partner reports his or her share of the partnership profits or losses on their PERSONAL income tax return -- the partnership doesn't have to file its own return. A partnership offers a deeper talent pool than does a sole proprietorship and the BURDEN of running the business is shared. Generally speaking, a partnership is stronger financially.
The partners are each JOINTLY and SEVERALLY liable for the debts and other obligations of the business. In addition, each partner is liable for the acts of the other partners (within limits). Because decision-making authority is divided, DISAGREEMENTS may arise which may cause friction between the partners. It would be a good idea to provide for a dispute resolution mechanism in the partnership agreement to overcome deadlocks.
A limited partnership is one in which there are two types of partners. A GENERAL partner has exactly the same rights and obligations as a partner in a traditional partnership arrangement. A LIMITED partner, contributes financially to the business but has minimal control over its management -- as well as a cap on personal liability set at the amount of the investment or the amount received from the partnership after it became insolvent.
In addition to the advantages discussed above of a normal partnership, a limited partnership offers a way for general partners to raise CASH without their having to involve outside investors in the day-to-day routine MANAGEMENT of the business, and without having to deal with the intricacies of creating a corporation and issuing stock.
For general partners, the disadvantages are the same as for a normal partnership. It should be noted that a limited partnership is more EXPENSIVE to create than a general partnership.
A corporation (or company) is an entity created and regulated by state LAW. A corporation is a SEPARATE entity from those who create it -- it is, in fact, known as a legal "person".
The shareholders (owners) are PROTECTED against the misdeeds of fellow owners and personal liability. As the corporation is a legal entity unto itself, only the assets of the corporation are at risk. However, lenders will typically require personal GUARANTEES from shareholders, so such protection is illusory. The corporate affords the owners a more favorable TAX treatment because of what is known as income splitting. The first portion (varies by jurisdiction) of retained profits are taxed at lower corporate income tax rates. Finally, because a corporation issues stock, it is an ideal vehicle for bringing in outside INVESTORS or rewarding employees with stock options.
A corporation is much more expensive to create. Also, you may find the PAPERWORK onerous. A corporation is a separate taxable entity and must file its own tax return -- which can lead to DOUBLE taxation, where income is taxed once in the hands of the corporation and again in the hands of shareholders. You may elect to be taxed as an S Corporation if eligible to do so -- where corporate profits and losses flow through the corporation DIRECTLY to the shareholders who then declare it on their personal income tax return. The S corporation does not have to file an income tax return itself. Talk to your lawyer or accountant for more information if this sounds like something you may be interested in.
LIMITED LIABILITY CORPORATION
A limited liability corporation fits somewhere between sole proprietorship / partnership and a corporation. The members (owners) are taxed on business profits which FLOW through the corporation to be declared on their personal income tax returns. A limited liability corporation is not a separate taxable entity. Like a corporation, however, it is a separate legal entity so all owners are protected from personal LIABILITY for business debts and other obligations. Owners will still be liable if they sign personal guarantees.
Limited liability corporations offer a more favorable tax treatment than a normal corporation because the Internal Revenue Service rules allow them to choose between being taxed as a partnership or a corporation. They are also more FLEXIBLE than a corporation -- profits and losses can be allocated independently of ownership interests. A limited liability corporation is also less expensive to set up and maintain.
Perhaps the greatest potential disadvantage is one of UNCERTAINTY. The limited liability corporation is a relatively recent creation of the legislature and, as a result, many issues that may be expected to arise have not yet been tested by the courts.
Elena Fawkner is editor of A Home-Based Business Online ... practical ideas, resources and strategies for your home-based or online business. Visit her website at www.ahbbo.com.
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