Congratulations, you’re ready to start your own business! You have your idea, your location, your funding, and possibly a business plan to get it all together. But, first things first–you’re going to have to plan how you want your business to be organized for tax purposes, accounting purposes, and most importantly, for liability purposes. So which business formation structure best serves your needs? You have a number to choose from, and here are the most common ways to do so:
- sole proprietorship (or entrepreneurship);
- general partnership;
- limited partnership (LP) or limited liability partnership (LLP);
- limited liability company (LLC);
- corporation; and
- nonprofit corporation.
The sole proprietorship is owned by one person and one person alone, and it doesn’t require state registration like other corporate structures. As such, in the eyes of the IRS and the law, the business is not separate from the owner. All business income and business losses have to be filed on the owner’s personal income taxes, and the owner is personally liable for anything and everything that happens on behalf of the business.
A general partnership very similar to a sole proprietorship, except that this business is owned by two or more people. Like the sole proprietorship, a general partnership does not have to be registered with the state, the partners are all personally liable for the business, and all partners have to file business income and losses on their personal income taxes.
A general partnership works best for small businesses where the partners rarely have to borrow money and their business has a relatively low risk of ever being sued.
Limited Partnerships and Limited Liability Partnerships
A limited partnership consists of at least two people going into business together, where one person (or a company) will be a general partner. The general partner is personally liable for the business’s actions and is in charge of the business’ operations. The limited partners invest in the partnership, but they have little control over business decisions. As such, they are not liable for the business’s actions.
Limited liability partnerships (LLP) make all partners have control over the business like they would in a general partnership, but none of the partners are personally for the business, as if they were limited partners. LLPs are generally reserved for professional organizations, such as law firms, physician groups, accountants, architects, etc.
Neither type of limited partnership is recommended for the average small business owner, as these partnerships are not simple to set up and are often expensive to do so.
Limited Liability Companies
For businesses who would like all the perks of a LLP but aren’t considered a professional service business, then limited liability companies (LLC) are definitely your best bet. Like a partnership, members of the LLC have to file their portions of the business’ income on their personal tax returns, and the members are not personally liable for the company’s debts and claims.
Also like a LLP, a LLC is costly and a bit complicated to set up.
Like a LLC and LLP, corporations separate the business from the owners, which prevents the owners from being personally liable for the business’ debts and claims. What makes it different from a LLC and LLP is the fact that it is completely separate from the owners as its own legal entity. Corporations pay their own taxes based on profits, not the owners. Owners only pay income taxes on the salaries and bonus income they receive from the corporation. Corporations are often set up to be the general partner in a limited partnership to further protect the limited partners.
Many small business owners rush to set up corporations, but they really only make sense for businesses that have a high risk of being sued and/or a high risk of acquiring a substantial amount of debt, or business owners who need to separate and protect their personal assets from the business.
A nonprofit corporation is set up similarly to a corporation, but nonprofit corporations are exclusively set aside for charities, religions, and other educational purposes. Nonprofits can raise money for their projects, but nonprofits generally do not have to pay taxes on any funds obtained for these projects because of how these projects benefit and contribute to their communities and not the business owners. For example, the Sesame Workshop is a nonprofit corporation, because all of the money they raise from putting on shows and selling DVDs and toys goes back into funding the organization and their contributions to children education across the world.
So which business formation best fits your needs? If you are needing a limited partnership, a limited liability company, or a corporation, do not try to set these organizations up on your own. You will need an experienced business law attorney to make sure that not only your formation is legally registered correctly, but also that it’s the most ideal structure for you and your business.