How to Form Your Business

As a new entrepreneur, you may be confused about how to legally form your business. Should you structure your company enterprise as a sole proprietorship, partnership, limited liability company or a corporation?

Since different organizational forms present their own set of advantages and disadvantages, you need to do your research before forming your company in order to make sure you choose the legal structure best for your business needs.

Sole Proprietorship

A sole proprietorship (SP) is an unincorporated business owned by one individual and is one of the easiest types of businesses to form. The key feature of a SP is that legally the business is considered to be an extension of the owner.

Consequently, the owner is personally responsible for any debts or liabilities incurred by the business. Additionally, any income generated by a SP is reported on the business owner’s personal income taxes.

As a SP, you can operate your business under your own name, or a trade name. If you choose to operate your business under a trade name, you will need to register your trade (or DBA – doing business as) name with your County Recorder’s office.

General Partnership

A general partnership is about as simple to form as a sole proprietorship. A general partnership (GP) is a business run by two or more partners, and can be easily formed by written or even oral agreement.

In a GP, each partner has “agency powers”, which means any partner can bind the entire business to a contract or business deal, and every partner in a GP is responsible for any debts or liabilities incurred by the business.

Limited Liability Company

A LLC offers the limited liability of a corporation in addition to the tax efficiencies and flexibility of a partnership. A limited liability company (LLC) is a hybrid type of legal structure which, in most states, may consist of a single individual (owner), two or more individuals, corporations or other LLCs.

The primary advantage of forming a business as a LLC is that business owners can protect their personal assets from the creditors of their business, meaning they will not be financially responsible for more than their investment in the company.

A LLC provides “pass-through” taxation, meaning all the income and expenses from the business get reported on the LLC owner’s personal income tax return.  However, this also means that single member LLC owners must pay self-employment tax on income generated in the LLC, requiring quarterly estimated payments to the IRS.

Keep in mind, not every business can operate as an LLC, for example companies that are involved in banking and insurance, so you need to check your state laws.

Limited Liability Partnership

A limited liability partnership (LLP) could be described as a cross between a corporation and a partnership where the partners have limited personal liability.

The primary difference between a LLP and LLC is that a LLP must have a managing partner that is liable for the actions of the partnership. As long as the other partners and investors don’t assume a managerial role, they receive liability protection.

Professional businesses are commonly organized as LLPs, but some states limit what professions can form an LLP, so you will need to check the laws of your state.

Corporation

A corporation is an independent legal entity owned by shareholders. The corporation itself is held legally liable for the actions and debts of the business, rather than the owner shareholders. Consequently, corporations are attractive to investors, since shareholders can generally only be held liable for their investment in stock of the company.

Corporations file taxes separately from their owners. This means that owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends. Any additional profits are subject to a corporate tax rate, which is usually less than a personal income tax rate.

For tax purposes, there are two types of corporate formations:

  • C Corporation

C corporations are subject to “double taxation”, first on company profits, and then on dividends paid to shareholders.

  • S Corporation

In order to avoid the “double taxation” of a C corporation, there is a special type of corporation created through an IRS tax election.  Eligible domestic corporations may elect to be treated as an S corporation, named after Subsection S of Chapter 1 of the Internal Revenue Code.

The main advantage of an S corporation is that it provides tax benefits in relation to excess profits, known as distributions. The S corporation pays its employees a “reasonable” salary as defined by industry norms ,while also deducting federal payroll taxes. Any remaining profits can then be distributed to the owners as dividends, which are taxed at a lower rate than income.

However, the profits and losses of the S corporation must be distributed to the shareholders in proportion to the shareholder’s interest. So, if a shareholder owns 20 percent of a S corporation, that shareholder must receive 20 percent of the profits or losses.

Corporations tend to be more complicated to form than LLCs because of higher administrative fees, complex tax and legal requirements as well as more paperwork and ongoing documentation.  Because of these issues, corporations are a better option for established, larger companies with multiple employees.

Before you decide which business formation is best for you, do your research. The Small Business Administration is a great resource. You may want to also consult with a business lawyer or get assistance from an online business formation company.

The information on this website is intended as general legal information only and should not form the basis of legal advice of any kind. Individuals seeking specific legal advice should consult a lawyer.