Choosing the Best Form of Ownership for your Business
The right structure-corporation, LLC, partnership, or sole proprietorship- has a lot to do with who will own your business and what its activities will be.
When you start a business, you must choose an ownership structure for it - for example, whether it will be a sole proprietorship, partnership, corporation, or limited liability company.
There’s no one choice that fits every business; your job is to pick the form that best meets your needs. This article introduces several of the most important factors involved in picking the right legal structure for your business, including:
- The potential risks and liabilities of your business
- The formalities and expenses involved in establishing and maintaining the various business structures
- Your income tax situation, and
- Your investment needs.
Risks and Liabilities
In large part, the best ownership structure for your business depends on the type of service or products it will provide. If your business will engage in risky activities - for example, trading stocks or repairing roofs - you’ll almost surely want to obtain liability insurance and form a business entity that provides personal liability protection, which shields your personal assets from business debts and claims. This means setting up a corporation or a limited liability company (LLC).
Formalities and Expenses
Sole proprietorships and partnerships are easy to set up - you don’t have to file any special forms or pay any fees to start your business. Plus, they don’t require you to follow any special operating rules.
LLCs and corporations, on the other hand, are almost always more expensive to create and more difficult to maintain. To form a LLC or corporation, you must file a document with the state and pay a fee, which ranges from about $40 to $800, depending of the state where you form your business. In addition, owners of corporations and LLCs must elect officers (usually, a president, vice president, and secretary) to run the company, and they must deep records of important business decisions and follow other formalities. They must also pay a fee to the Franchise Tax Board (currently $800.00 per year) for the privilege of doing business in California
Business owners who are starting out on a shoestring often care most about spending as little money as possible on legal structure of their business. For them, it can make the most sense to form the simplest type of business - a sole proprietorship (for one-owner businesses) or a partnership (for businesses with more than one owner). Unless yours will be a particularly risky business, the limited personal liability provided by a LLC or a corporation may not be worth the cost and paperwork involved with creating and running one.
Income Taxes
When it comes to taxes, sole proprietorships, partnerships, and LLCs come out about even. These three business types are “pass-though” tax entities, which means that all of the profits and losses pass through the business to the owners, who report their share of the profits (or deduct their share of the losses) on their personal income tax return. Therefore, sole proprietors, partners, and LLC owners can count on about the same amount of tax complexity, paperwork, and costs.
One thing to bear in mind is that owners of these unincorporated businesses pay income taxes on all net profits of the business, regardless of how much they actually take out of the business each year. Even if all of the profits are kept in the business checking account to meet the upcoming business expenses, the owners must report their share of these profits as income on their tax returns.
Unlike other business owners, the owners of a corporation do not report their shares of the corporate profits on their personal tax returns. The owners pay taxes only on profits paid out to them in the form of salaries, bonuses, and dividends.
The corporation itself pays taxes, at special corporate tax rates, on any profits that aren’t deductible - that is, profits that are left in the company from year to year (called “retained earnings”) and dividends (portions of profits that corporations sometimes pay out to shareholders in return for their investments).
This separate level of taxation adds a layer of complexity to filing and paying taxes, but it can be a beneficial to some businesses.
Not only do owners of a corporation avoid paying personal income taxes on profits they don’t receive, but because federal corporate income tax rates on the first $75,000 of corporate income are lower than the federal individual income tax rates on that same amount of personal income, a corporation and its owners may actually pay fewer overall taxes than owners of unincorporated businesses.
Investment Needs
Corporations - unlike other types of business structures - provide a built-in stock structure that makes it easier to attract investment capital, including the possibility of raising public capital by make a public offering of shares. In addition, this stock structure allows businesses in the Internet and other hot technology industries to attract and retain key employees by issuing employees stock options.
But for businesses that don’t need to issue stock options and will never “go public,” forming a corporation probably isn’t worth the added expense. If it is limited liability that you want, an LLC provides that same protection as a corporation, but the simplicity and flexibility offered by LLC’s offer a clear advantage over corporations.
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