If you are considering starting a business, it's important to put careful consideration into the type of business structure you will have. The type of business you select can impact how much you pay in taxes, the paperwork you must file, your personal liability and even your ability to raise money. Choosing the right type of business takes research and careful assessment. In this article, we will discuss the different types of businesses and offer tips on how you can choose which type to start.
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Types of businesses
Here are the most common types of business structures, although it's important to note that liability, ownership rules, taxes and filing requirements can vary by state.
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This is typically the simplest type of business, with only a single person or a married couple responsible for all the company's profits and debts. If you intend to work alone, this may be the best option for you. This type of business can be especially appealing because income and expenses are included on your personal income tax record. Your profits and losses are recorded on the Schedule C tax form and the amount is transferred to your personal tax return. Losses you suffer in the business can offset income earned from other sources. With this type of business, you also have complete ownership and make all the decisions.
The disadvantage of a sole proprietorship is that you are liable, personally, for your company's liabilities. This means that your personal assets could be placed at risk to satisfy a business debt or settle a legal claim filed against you.
A partnership can be an ideal choice if your business is going to be owned and operated by multiple people. This type of business comes in two forms: general partnership and limited partnerships. With a general partnership, the partners assume responsibility for the debts. With a limited partnership, though, there are both general and limited partners. The limited partners are investors only and have no control over the company and are not subject to liabilities. The general partners own and operate the business and assume the liabilities.
Unless you intend to have multiple passive investors, the limited partnership may not best the best type of business to start as a new business owner because of the administrative complexities and required filings. If you expect to have two or more partners who are actively involved in the business, a general partnership is easier. One of the advantages of this type of business is the tax benefits. A partnership doesn't pay tax on its income but instead passes the profits and losses on to the partners. They are typically more expensive to start because more extensive accounting and legal services are required.
Limited liability company (LLC)
This type of company allows owners, partners and shareholders to limit their personal liability to protect their personal assets. An LLC is not incorporated but it enjoys the limited liability of a corporation. The LLC can be taxed as a sole proprietorship, partnership or corporation.
Some of the benefits of an LLC include no limitations on the number of shareholders the business can have. Also, any owner or member can have a full participatory role in the operation of the business. There is also flexibility with the distribution of profits. Profits and losses don't have to be distributed in proportion to the money that the investor puts in. The disadvantage of this type of business is that because LLCs are a relatively new business structure, the tax treatment can vary by state.
Corporation - C corp
Corporations offer the strongest amount of personal liability protection, but the cost to form a corporation is also higher. Corporations also require more extensive reporting, record-keeping and operational processes. Corporations are completely independent of shareholders. They pay income tax on profits and in some cases can be taxed twice. They do have an advantage when raising capital because they can raise money by selling stock. Stock options can be useful in attracting employees.
Corporation - S corp
An S corporation has the liability protection of corporations along with several tax benefits. The owners of S corporations can use the cash method of accounting if they don't have inventory. They can have up to 75 shareholders, which makes it possible to attract more capital. S corporations must file articles of incorporation like all corporations and hold directors and shareholder meetings. They also must allow shareholders to vote on major decisions. S corporations can only issue common stock, which could impact the corporation's ability to raise capital.
Corporation - B corp
A B corporation, also called a benefit corporation, is a for-profit corporation that is driven by mission and profit. They are taxed in the same way as C corporations but are focused more on purpose, accountability and transparency.
Corporation - nonprofit
Nonprofit corporations are organized with the intent of doing philanthropic work. Because their work benefits the public, they can receive tax-exempt status and not pay taxes on profits. They follow organizational rules that are like a C corp but also have special rules regarding profits.
How to choose which type to start
Here are the main factors you will need to consider before choosing the type of legal structure for your business.
Your goal when selecting a type of business is to identify the one that allows for maximum flexibility with the ownership structure. You need to consider the goals, concerns, needs and financial situations of each owner.
Another factor you need to consider when forming your business is the extent to which you need to be protected from liability. You need to examine the potential liability of your organization and decide if you can personally afford the risk. If you cannot, a partnership or sole proprietorship is likely not the best type of business to start.
You will need to establish the level of complexity you want to take on with your business. Sole proprietorships are the simplest option and incorporating your business can become highly complex, with state and federal reporting requirements.
You will also need to consider the tax implications for the organization and what the opportunities are for minimizing taxation. There are more tax options for corporations than partnerships or sole proprietorships. Double taxation can be a problem with corporations but can be avoided with an S corp.
You need to determine the amount of control you want over the business. If you need to have complete control, an LLC or sole proprietorship may be the best choice. While a single person can control a corporation, as the business grows, it will become a board-directed entity.
If you plan to seek outside funding for your business, you may want to establish a corporation. Corporations can secure additional funding and sell stock, as opposed to sole proprietorships, which can only obtain funding through their personal bank accounts or by taking on partners.
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