The Five Ways to Set Up Your Business:
Their Pros and Cons
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If you would like a chart with this information, click here.
Sole Proprietor
Why choose this form of business?
This is the most basic form of doing business. As one tax analyst puts it, “You keep all the profits and accept the entire risk of loss. It is capitalism at its most basic.” Sole Proprietorship is best for very small businesses and in early start-up phase.
How complicated is it to create and operate?
No formal action need be taken; you merely start doing business. However, the municipality or state in which one resides might require various licenses, depending on the nature of the business and where it’s being operated.
What tax issues should I consider?
You report business profits or losses on an individual tax return. On Schedule C, you list business income and take deductions for expenses. The net profit is taxed at personal income tax rates (federal rates range from 15 to 39.6 percent). If you lose money, you cannot deduct losses but can carry them forward to the next tax year. Should you make a profit that next year, you deduct the losses accrued from the previous year (or years) from your profit. However, you cannot reduce your net business income to less than zero.
Would my assets be at risk if I'm found liable for a problem?
You are personally liable for every business debt, just as if you had incurred such liabilities as personal expenses. That means all of your personal and business assets are at risk.
How easy is it to raise money?
Most banks and other lending entities will require personal collateral (home equity or other valuables). Too often, capital is generated only from your personal resources—by borrowing on credit cards or from family.
What happens to my business if I sell, become disabled, or die?
You have no separately existing business entity. Thus, if you die or become incapacitated, your business goes with you. Selling is a bit more feasible—but only if you have an established service business or a readily assumed, product-based business. For these reasons, estate planning becomes vital for sole proprietors.
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General Partnership
Why choose this form of business?
You create this structure by an agreement. It can be an oral agreement, but it should be in writing. To avoid unnecessary troubles, it is wise to use the aid of an attorney. The agreement should set forth the respective ownership interests of the partners, the extent of each partner’s investment in the business, and other important matters. With the coming of both limited liability companies and partnerships (see below), general partnerships seem to be growing obsolete.
How complicated is it to create and operate?
Because so many terms must be plugged into the agreement—including the rights and obligations of each partner, what happens if a partner dies, and so forth—a partnership can be more complicated than it might initially appear. With so much to consider, it’s a good idea to have a lawyer advise you on the issues and to prepare and negotiate the agreement. Problems can arise when partners have differing views of how the business should operate or feel that one partner is doing more work than the other.
What tax issues should I consider?
Although it is not taxed as a single entity, total profit and losses are tallied for the business. Each partner then files an individual tax return (using Schedule K-1) that includes the amount of his respective tax liability and is taxed accordingly. Setting up a retirement plan becomes complicated because if all partners can’t agree on the type of plan, it might be impossible to have a plan.
Would my assets be at risk if I'm found liable for a problem?
Each partner is personally responsible for all of the business liabilities of the partnership and even for the individual liabilities incurred by partners during the course of partnership activities. Each partner’s personal assets are potentially at risk. If a bill isn’t paid, you can be made to pay the entire amount if your partners are unable to pay their respective shares.
How easy is it to raise money?
Partners contribute time, money, or property to receive equity interest. These contributions must be tracked and will have ramifications for each partner. Borrowing from banks or other lending sources is as problematic as for sole proprietors; personal collateral is often necessary.
What happens to my business if I sell, become disabled, or die?
In the partnership agreement, partners can provide for the contingency of another’s death, incapacity, or desire to sell his equity. One option is a buy/sell agreement that can state that upon death, the dead partner’s heirs will receive the proceeds of a life insurance policy that has been taken out for the purpose of buying out the interest of the deceased partner. In return, the heirs will lose all rights, title, and interest in the partnership business.
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C Corporation
Why choose this form of business?
By incorporating your business, you create an entity that is separate and distinct from you as an individual. Special laws and taxes apply to any corporation. A C corporation (the standard type) may not be the best structure for a small business, especially one in start-up phase. The formalities are many, and the tax consequences may leave less money in your pocket. Note that the liability protection you might be seeking in a C corporation can also be found in a limited liability company or a subchapter-S corporation. However, if your business is growing large and you want to raise money through the sale of stock, a C corporation may be the way to go.
How complicated is it to create and operate?
To incorporate, you must file articles of incorporation, create corporate bylaws, and fulfil other state requirements. Stock must be issued, even if you’re the sole shareholder. If you commingle personal and corporate assets or otherwise fail to conduct the corporation as a separate and distinct entity, you may lose your right to limited liability—which is a primary reason for forming a corporation.
What tax issues should I consider?
The business must report income on a corporate tax return, separate from shareholders’ returns. Also, regardless of profitability, many states have minimum taxes that are owed by corporations. Shareholders will be taxed for dividends received, and, of course, any salaries from your corporation will be taxed at individual rates. Corporate tax returns are more complicated than individual returns, which generally means higher fees paid to a tax professional. On the other hand, corporations are usually taxed at a slightly lower rate than individuals—34 percent maximum versus 39.6 percent.
Would my assets be at risk if I'm found liable for a problem?
Limited liability for shareholders is a vital benefit. Under normal circumstances, a corporate owner’s liability is limited to funds invested in the stock. Stockholders cannot be held personally liable for corporate actions, and creditors are limited to corporate assets when seeking to collect monies owed.
How easy is it to raise money?
Corporations have a method of raising money not available to other types of business structures. They sell stock to the public. Furthermore, with a standard C corporation, there are no limits as to who can own stock or to the number of shareholders, thereby maximizing the potential access to capital.
What happens to my business if I sell, become disabled, or die?
Once formed, a corporation continues in existence until formally shut down. Thus, if a key player in the corporation dies, formal action is not required by the corporation to deal with the problem. The ownership of the deceased will simply pass to the heirs. Also, under most circumstances, stockholders can sell their stock whenever and to whomever they please.
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Subchapter-S Corporation
Why choose this form of business?
To combine corporate liability protection with the tax aspects of a partnership, consider this popular structure. There are, however, restrictions as to who may participate, which can be problematic when raising capital. For example, in addition to the restriction on the number of shareholders, foreign nationals may not hold subchapter-S stock.
How complicated is it to create and operate?
Creating a subchapter-S corporation is about as complicated as forming a standard C corporation (see above).
What tax issues should I consider?
Shareholders are taxed as if they were in a partnership, and they file individual rather than corporate tax returns.
Would my assets be at risk if I'm found liable for a problem?
As with a C corporation, there is no stockholder liability beyond the assets of the corporation.
How easy is it to raise money?
A subchapter-S corporation can have up to 35 stockholders. That enhances its ability to raise working capital. However, if you wish to offer shares to investors at large, you will have to form a standard C corporation.
What happens to my business if I sell, become disabled, or die?
A subchapter-S corporation offers the same flexibility as a C corporation (see above).
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Limited- Liability Company
Why choose this form of business?
This relatively new business structure can be formed in any of the 50 states. A limited liability company (LLC) has the limited liability of a corporation but the flexibility and tax status of a partnership. That makes it an up-and-comer in business circles.
How complicated is it to create and operate?
A filing must be made with the appropriate state authorities. Usually this consists of the articles of organization and the operating agreement. It is important to dot all the “i’s” and cross all the “t’s” when creating this structure. Therefore, you should retain an attorney who understands your state’s specific laws.
What tax issues should I consider?
In fact, tax liability is the same as that of a partnership. The IRS has, for the most part, accepted the LLC, but be sure to ask if the law in your state has been approved. You report profits and losses on a personal, rather than corporate, tax return.
Would my assets be at risk if I'm found liable for a problem?
As the name implies, liability is limited to the assets of the LLC.
How easy is it to raise money?
The restrictions on securing capital are the same as those of a general partnership. Your revenue options are limited because you cannot raise money through shareholders.
What happens to my business if I sell, become disabled, or die?
You will have to engage in succession planning, as you do in a general partnership (see above).
If you would like a chart with this information, click here.
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