What type of company should I form?
There are several business types and structures to choose from. Each has its own list of pros and cons, including complexity of formation, liability protection, and tax implications.
Here’s a quick overview of the common business types. Of course, if you’re not sure what decision is best for yourself and your business, you should consult a qualified professional — but hopefully this information will give you a general idea of the available options.
Lots of entrepreneurs start with a sole proprietorship or general partnership (and then potentially switch to a different structure once their business expands). Sole proprietorships are the simplest type of business organization to establish. In fact, you don’t really have to do anything to become a sole proprietor (though you may need to get a license before you can actually do business). You don’t need to complete any public filings or take any formal steps to create a sole proprietorship.
A sole proprietorship is not considered to be a separate legal entity from its owner. The business’s legal name is your name, and its profits and losses are included on your personal tax return. Sole proprietors have personal liability for business debts and lawsuits.
Sole proprietorship pros
- They’re the easiest and least expensive form of business entity to organize.
- Sole proprietors are in complete control and may make decisions by themselves (within the parameters of the law, of course).
- Sole proprietorships can be easily converted into another type of business entity in the future.
Sole proprietorship cons
- Unlimited liability: the owner will be held personally liable for all debts against the business.
- Because of the unlimited liability, sole proprietorships may be at a disadvantage in raising funds.
- The business entity dissolves upon the retirement or death of the owner.
A partnership is an agreement in which two or more people agree to share in all assets and liabilities of a business. With a general partnership, the law does not distinguish between the business and its owners (just like a sole proprietorship). Each owner has unlimited personal liability and full authority to conduct business for the partnership.
You don’t need to file documents with the state to form a general partnership, but you will need to get an EIN (employer ID number) as your tax ID and many states require that you register your DBA (“doing business as” name). Most partnerships also create a written partnership agreement with details on how you’ll make decisions, resolve disputes, and allocate profits and losses.
General partnership pros
- Low start-up costs.
- Pass-through tax treatment: Like in a sole proprietorship, no taxes are paid at the business level. Instead, the individual partners are taxed on the income they receive from the partnership. Each partner pays taxes on their share of the business income on their personal tax returns.
- Limited regulation.
- Broader management base and flexibility of financing.
General partnership cons
- Unlimited liability: partners will be held personally liable for all debts against the business.
- Authority is divided.
- It might be difficult to raise funds.
- A general partnership will end upon the bankruptcy, withdrawal, or death of any of the partners.
A note on other partnership types
In addition to general partnerships, you can also form limited liability partnerships and limited partnerships. These partnerships are generally more complex to form than a general partnership, and they offer liability protections that general partnerships do not.
Azlo isn’t currently able to offer accounts for these other partnership types, and since the requirements and formation process varies from state to state, we won’t cover them extensively here. They’re definitely an option to be aware of, however, and they merit future research if you’re drawn to the pros that partnerships offer but would like to protect yourself from liability.
LLCs are the most flexible of all incorporated business entities. They’re a relatively new type of business structure that’s specific to the US. An LLC is more complex to form than a general partnership, but can be easier to form than a corporation.
LLCs are a legal structure that’s governed entirely under state law, rather than a federal tax structure. That means LLCs can choose to be taxed like a corporation or to have pass-through taxation like a partnership or sole proprietorship.
- LLCs have great organizational and managerial flexibility.
- The liability of a member of an LLC is limited to the member’s personal investment in the company.
- LLCs offer the ability to choose your tax structure.
- LLCs do not have to follow some of the corporate formalities that apply to corporations.
- LLCs tend to have a much more complex tax filing system than other entities.
- Tax and liability treatment of LLCs is not uniform across state lines.
There are two types of corporations: S-corporations and C-corporations. Both are legal entities that are separate and distinct from its members (shareholders). A corporation can acquire assets, go into debt, enter into contracts, sue, or be sued. Ownership interests in a corporation are usually easily changed. Shares may be transferred without affecting the corporation’s existence or continued operation.
The primary difference between C-corps and S-corps is the way they’re taxes. S-corps are “pass-through” businesses which means the profits and losses are passed through to the shareholders’ individual tax returns. C-corps are taxed as as a separate entity before the funds are disbursed to employees and shareholders, where they may be taxed again (this is referred to as “double taxation.”
Businesses do need to meet specific requirements in order to be eligible for S-corporation status.
- Limited liability.
- Possible tax advantages.
- Ownership is transferable.
- It’s easier to raise capital.
- The most expensive form of business to organize.
- Possible double taxation of profits for C corps.
- Corporations must continually observe corporate formalities that can be time-consuming and costly, e.g., holding periodic board meetings and annual shareholder meetings and abiding by various record-keeping requirements.
- Corporations are monitored by federal, state and some local agencies, and may have more paperwork than other types of businesses.
To sum it all up
As you can see, the business structure you choose will have a significant effect on your business itself.
When you’re making a decision, think about your business’s growth — both past and future. If you’re in the early stages, a structure intended for smaller and simpler businesses is likely the way to go … but if you have boundless ambition and you’re poised to scale quickly, you might be better off choosing a more complex structure designed for larger businesses. Conversely, if your business is designed to stay small (regardless of its success) and doesn’t particularly need or want investors or shareholders, you’ll likely want a business structure that’s easy to create and manage.
Also, remember that the right structure for your business can change over time. Most folks start with a sole proprietorship or partnership before forming an LLC or corporation, and some business owners try out several different structures before they find the right fit. Although changing your business structure takes work, it’s a very doable and normal step for an evolving business to take.
Hi there! This post exists to offer you (hopefully) useful information but it cannot take the place of personalized professional advice. Please consult a qualified expert if you have questions about your business. Also, Azlo doesn’t endorse any third-party sites that are linked here.
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