Before anything else, the first decision to be made before even starting to operate is the best way to legally form the company. Different operations will better benefit from one form, compared to another. Generally, depending on the type of business you will be running, it’s good to speak to an accountant & in some cases also a lawyer, before committing to one type. The good news is, however, that you can always close the current one & open a different one when necessary. That said, it’s best to choose the best type upfront, to avoid unnecessary paperwork & fees.
The 5 common forms are:
• Sole proprietorship
• Partnership
• Limited liability company (LLC)
• Corporation
• S-Corporation
The structure chosen will affect how easy it will be to obtain financing, the way taxes are paid, accounting records, the risk involved with personal assets, the level of control you have over the business, as well as many other parts of the business. For a beginner It is often a good idea to start with the simplest form possible for the given situation and get the business running, and once the business flow has been established, it will be much easier to pick the right form. For this reason , the sole proprietorship could be the best starter option for many, and as the business grows and the burden of taxes or the potential for liability grows, the situation will dictate to pick a different form for obvious reasons.
Sole Proprietorship
A sole proprietorship is the simplest &least regulated of the above mentioned business types. In this type the business is the owner, the business liabilities (tax or other legal liabilities) are liabilities of the owner & in case of owner’s death, the business ceases to exist. The sole proprietor (owner) has full control of the business & all the profits are personal as well.
Disadvantages
- all of the personal & business assets of the owner are at risk in this business type
- legal judgments for damages from the operation of sole proprietorship can be enforced against the personal assets of the owner
- insurance premiums for this type of liabilities are insanely high & growing
- potential difficulty in getting business loans. On the other hand getting business loans for a startup is very difficult either way, however, personal loans can further complicate the situation in case of sole proprietorship
Advantages
- there is complete freedom of operating the business anyways the owner wants (aside from legal restrictions that may apply)
- aside from keeping sufficient records for taxes, there are no legal requirements for the way the business operated or how the paperwork is kept
- it’s the least regulated type of business, generally the only license necessary is a local business license, however some other requirements may apply depending on the location. It may be necessary to register with local, state, and federal tax organizations for a tax ID
- the losses of the sole proprietorship are deductible against any other income & the profits are taxed once. This can be a great advantage for a small startup
Partnership
A partnership is two or more people that join together to operate a business, generally based on a partnership agreement of some kind. Each of them contributes some kind of assets, like property, money, labor, a skill, and they all expect to share the profits or losses of the business. A partnership doesn’t necessary imply having a formal partnership documents, nor it’s required, that said, it’s always a good idea to have one.
The simple fact of sharing expenses is not considered a partnership. For a legally acceptable partnership to which the appropriate tax code will apply, the following factors are considered:
• The partners’ conduct in carrying out requirements of the partnership agreement
• The relationship of the parties involved
• The contributions of each party to the business
• The control each partner has over the income and the purposes the income is used for
Disadvantages
- potential conflict between partners
- all of the personal assets of each partners are at risk, which creates higher risk environment than the one in sole proprietorship, since one does not have direct control over what other partners may do. Regardless of who’s fault the damaging actions might have been, the liability spreads out on everybody involved. Both financial & other legal liabilities apply. In addition each partner is liable for possible negligence by employees as well
- the partnership is generally terminated in case of death of one of the partners & new agreement is necessary if the rest decide to continue operating
- certain benefits of corporate organization are not available to a partnership (eg. certain pensions, financing through public stocks, profit-sharing arrangements)
Advantages
- opportunity for greater business credit, however, not as good as a corporation
- in some cases certain tax advantages, as opposed to a corporation, no double taxation
- less start-up costs, limited regulation
Limited Liability Company (LLC)
LLC or limited liability company is a hybrid type of business between traditional partnership & a corporation. It offers the tax benefits of a partnership & the limited personal liability of a corporation. A LLC can have one or more owners, as well as nonmember employed managers.
Disadvantages
- potential conflict among the owners
- LLCs are subject to more paperwork than sole proprietorship or partnership
- LLCs are subject to more state regulations compared to a sole proprietorship or partnership.
- More fees apply by the states for LLCs
- it may be difficult to transfer or sell ownership for a member
Advantages
- limited liability for the members (similar to corporation shareholders)
- due to limited liability & no requirements to personally perform any management task, LLCs is more attractive for investors
- LLCs are generally taxed as partnerships, with benefits of less individual financial risk
- flexible management structure, no direct management by owners is necessary
- more flexibility distribution of profits & losses, compared to corporations
Corporation
Corporations are subject to noticeably more state regulations during the formation as well as operation. The corporation is an entity created by filing Articles of Incorporation with the appropriate state authorities. This gives it legal existence & the right to carry on business. After this adoption of corporate bylaws (internal operation & management rules) is the first thing that is generally done by the corporation.