One of the most significant decisions you will come across as a new business owner is the structure under which you will operate your business. The business structure impacts everything from day-to-day operations to tax returns and personal liability. Each structure has its own legal and tax ramifications and determining your business goals will play a large factor when determining the best structure for you.
A sole proprietorship, a common business structure, is one in which the company is unincorporated and owned by a single individual. This individual is personally responsible for the business’ debts and liabilities and the business is, essentially, considered one with the owner. In terms of taxation, a sole proprietorship’s expenses and revenues are included on the owner’s personal income tax return through form Schedule C and need to be paid on a quarterly basis. This inclusion is an advantage in the situation where business losses may offset excessive income from another source, lessening the personal income tax burden.
Another common business structure is the general partnership. This unincorporated business structure is very similar to a sole proprietorship in formation and taxation, but the ownership is instead split between two or more general partners who share equal liability. Individuals can inadvertently create a general partnership by commencing business together which will automatically give rise to a general partnership. Although this type of company is relatively simple to form, the operation is complicated by the fact that general managers share liability, responsibility, decisions, profits, and losses. The Schedule K-1 is utilized for taxation of this entity as it specifies the tax burden each partner is responsible for. Like a sole proprietorship, the owners are one with the business and are personally held liable for the actions and inactions of the business. In contrast, however, they are also held liable for the decisions and choices of other general partners.
Limited partnerships (LP), limited liability companies (LLC) and corporations are all incorporated and generally shift the liability from the individuals personally to the business itself. A limited partnership is one in which there exists at least one general partner and at least one limited partner. The general partner incurs unlimited liability for the company’s debts and obligations and the limited partners liability is limited to their investment in the company. Although limited partners often have no managements rights, the documents incorporating the business outline the rights to vote on financial decisions such as: the disposal of corporate assets, amendments to the partnership agreements, admission or removal of partners etc.
On the other hand, a general partner is an owner who generally controls the daily operations, decisions, and management of the company while a limited partner is essentially a capital investor with no say in the general partner’s responsibilities. Limited partnership agreements are advisable related to these entities to specify the amount of equity each partner holds in your company and, consequently, each partner’s tax burden, and to determine how the partnership will be operated. This partnership also utilizes a Schedule K-1 related to the taxation burden of each partner, limited and general. Like general partnerships, limited partnerships require each partner to file their company taxes on their personal income tax return (the “pass-through” method). Therefore, this structure is often utilized by business owners looking to raise capital while maintaining control of the company decisions.
A limited liability company can also be used to encourage investments while maintaining company control. A limited liability company is essentially a hybrid business structure of a partnership and a corporation making it an optimal choice to avoid personal liability while having a contract that governs how the business will be managed and profits distributed. This business structure provides limited liability to its owners through the separation of the business’ assets from the owners’ personal assets. This protects the owners from the burden of the company’s debts and liabilities when properly operated.
An LLC can be taxed in a variety of ways. If it is a single member LLC, the company will be taxed as a sole proprietorship in the methods discussed above. If it is a multi-member LLC, the company can be taxed as a partnership, again through the pass-through method, or as an S Corporation. To elect to be taxed as an S Corporation, which reaps the benefits of lower employment tax and pass-through, the LLC will have to file forms with the IRS. A disadvantage, however, is that LLCs may be required to dissolve upon death or bankruptcy of a member.
Lastly, we have the corporation business structure. A corporation is often used when an owner intends to sell equity shares or other securities of the business, even though an LLC can be used similarly. A corporation can be classified in two categories: C Corporation and S Corporation. The C Corporation is the default structure for a corporation and a company must qualify under specific restrictions to file as an S Corporation, which has certain tax benefits.
In general, a corporation takes on a life separate from its shareholders, directors and officers and has limited liability protection. The shareholders contribute capital investments and elect the board of directors, who in return elect the officers, the individuals responsible for the day-to-day operations of the company. In a C Corporation, there can exist an unlimited number of shareholders, there is no restriction on ownership or share class, and there is a lower maximum tax rate. Unfortunately, they are exposed to double taxation through the taxation of its earnings and dividends. In an S Corporation, the owners face only single taxation through the pass-through method but may have no more than 100 shareholders. Shareholders must be individual U.S. citizens or residents and a company generally cannot be a shareholder. However, there are certain exemptions for trusts, estates and some 501(c)(3) nonprofits.
All business entities are controlled by state law unless there is a governing document, such as a company or operating agreement. If you are interested in forming a business, but are unsure about the structure that would reap the most benefits for you and sustain your business model, please reach out to one of our experienced business attorneys today at (210) 503-2800 to make an inquiry.