In the Finance 101: Starting a Business article released earlier this week, we briefly covered business entities. In today’s article, we talk about each business entity in more detail.
You must know your options before you form a business!
Each entity has its own details and tax requirements. Consider your situation and the future state of your business when choosing an entity. Let’s get started!
Common business entities include…
Sole Proprietorship
A sole proprietorship is the simplest to start, as it is not a legal entity. A sole proprietorship is a business that is owned by one person, who is responsible for its debts.
You can conduct business under your own name, or under a fictitious name with a “DBA” or “doing business as” that you file with the state. Sole proprietorships are easy to set up. Just register your name or DBA and ensure proper licensing!
However, one huge disadvantage of a sole proprietorship is that you are responsible for any business debts. Also, if someone sues the business, your personal assets are at risk.
You can mingle business and personal income together in a sole proprietorship. Filing taxes is easy, since this form of business is indistinguishable from its owner.
The owner of a sole proprietorship files a Schedule C with their normal 1030. You record profits and losses are recorded on the Schedule C as well. If the company has an overall loss, this helps offset any personal income.
Partnership
Generally, two individuals own and operate a partnership. However, you can have more than two partners. There are two types of partnerships: general partnerships and limited partnerships.
In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and obligations.
In a limited partnership, general partners own, operate, and assume liability for the business, and limited partners serve only as investors. The limited partners have no control over the company and do not have the same obligations.
Draft a partnership agreement prior to legally forming a partnership.
Outline each partner’s share of ownership, responsibilities to the business, and financial obligations. Additionally, describe the process for handling disputes, making business decisions, and the buyout process.
According to Entrepreneur, “one of the major advantages of a partnership is the tax treatment it enjoys. A partnership doesn’t pay tax on its income but ‘passes through’ any profits or losses to the individual partners.”
The partnership files its own tax return and each partner reports their share of income (or loss) on a Schedule K-1.
Limited Liability Company
A limited liability company allows a sole owner or multiple owners to run and operate the business without personal liability for any business debts. This is one of the most popular business entities.
An unlimited number of individuals, corporations, and partnerships can participate in an LLC. However, ownership interests in an LLC are not transferrable without restriction.
This makes the LLC unworkable for major corporations, who can attract large amounts of capital through easily transferable stock. An LLC must pass the “transferability restriction test” to have transferable stock.
An LLC is usually filed under the owners’ personal tax returns. However, filing as an S-Corporation with the IRS means an LLC can be taxed as a separate entity. The LLC does have to meet certain requirements, but as long as the company isn’t too large it usually can.
LLCs are the newest legal form for businesses, which means there are fewer regulations.
Corporation
A corporation is a form of business that operates as a separate, legal entity. A board of directors runs the corporation.
A corporation has all of the legal rights of an individual, with minor limitations. Usually, you file articles of incorporation with the state where the business will operate. After the company is incorporated, each of the owners get stock in exchange for cash and other assets.
Corporations must have annual shareholder meetings, in which board members are voted in (or voted to stay as-is). Most corporations elect officers, including a president, secretary, and treasurer to conduct the day-to-day operations and decisions of the business.
Since a corporation is its own entity, the most that owners have to lose is their original investment. Owners are not personally liable for corporate lawsuits or damages.
Unlike the other entities, corporations file their own returns and pay their own taxes. The IRS automatically categorizes newly formed corporations as C-corporations.
If it meets certain requirements, a C-corporation can file as an S-corporation. An S-corporation is ideal for small business owners because liability still remains within the business, but income or losses are passed through to their individual returns.
This means that an S-corporation does not pay its own taxes, unlike the C-corporation. S-corporations still have to follow the same requirements as C-corporations.
An S-corporation is very similar to an LLC. However, there are some differences.
For example, other corporations, trusts, LLCs, or partnerships cannot own an S-corporation. Also, LLCs have more flexibility when it comes to distributing profits.
Related: 5 Things to Do Now to Set Your New Business Up for Success
There is quite a lot to learn when it comes to business entities. However, a CPA or business attorney can answer all of your questions!
Have you formed a business entity? What was your experience like? Share your thoughts with the community and leave a comment below!
2 thoughts on “The Rundown on Business Entities”
This information is really good because when someone is first starting a business they tend to focus on going with the least expensive option upfront, but that isn’t always the best option depending on the circumstances. So great job shedding light on this info.
I’ve always wondered about the differences between businesses when it comes to owning. This article did a great job of answering my questions about the main differences between each. Thanks!!