Income School Blog

What Legal Form Should Your Business Take?

Most businesses take one of five forms.  And which one is right for your business depends on what your goals are.

So if you are starting a business, it’s likely that it’ll take one of the following five forms.

  • Sole Proprietorship
  • Partnership (general or limited)
  • C Corporation
  • S Corporation
  • Limited Liability Company (LLC)

The two major differences between these five forms is the tax status and the protection that the organization offers to the owners.  Let’s look at each of these and compare them on those two differences.

Sole Proprietorship

This type of business comes into existence when a single person decides to start doing business.  There are no formalities required to start one of these.  The business and the owner are treated as one entity for both taxes and liability.  This means that first, the owner is taxed for all earnings in the business, whether they take them out of the business or not.  And second, the owner is liable for anything that the business does.  So if the business is sued or goes bankrupt, the owner’s personal assets can be lost.

Partnership

A partnership is just a business entity that is owned by two or more people.  They should consist of a written agreement between the partners on how the business will be run, how profits will be distributed, salaries, responsibilities, and how and when the business will be dissolved.  But this agreement typically exists between the partners.

Like sole proprietorships, partnerships are considered pass-through entities for taxes.  The partners are taxed on business earnings.  In addition, the partners are liable for the business and their personal assets can be pursued.

In some states, partnerships and sole proprietorships are required to file forms with the government.

Partnerships in the United States are also required to get an Employer Identification Number from the federal government which is used by the IRS to identify your business.

C Corporation

C Corporations are completely different on both issues.  In C Corporations, the owners are protected from liability.  The business truly is a separate entity so in the event of bankruptcy or lawsuit, the owners’ assets are protected.  The C Corporation is also considered a taxpaying entity.  This means that earnings for the corporation are taxed at the corporate level.  Then, when any earnings are dispersed to owners as dividends, they are taxed again at the individual level.  This is commonly referred to as double taxation and is a downside of this legal form.

S Corporation

S Corporations are a sort of hybrid between a C Corporation and a Partnership.  They have the same tax status as a partnership, but they are protected from legal liability.  Thus, the owners’ personal assets are safe from any action against the company.  S Corporations do have some specific restrictions though.

  • They can only have one classification of stock
  • They have to be wholly owned by US citizens and get at most 80% of their revenue from outside the US
  • They can only have up to 75 stockholders
  • They can get up to 25% of revenue from passive investments
  • They can only have individuals, estates and certain trusts as shareholders

Limited Liability Company

LLCs are a lot like S Corporations in that they get the limited liability that a corporation offers while they get the tax status of a partnership.  LLCs have operating agreements that are effectively the same as a partnership’s partnership agreement.  One thing to be aware of, though, is that LLCs are state-level organizations and the regulations surrounding their formation and operation can vary from state to state.

So how do you decide what’s best for you?

Well, the first step is to think about who is going to own the business.  If it’s one person, then a sole proprietorship or an LLC could be the way to go.  If it’s more than 75 people than an LLC or a C Corporation may be your only choices.

Next, think about where you’ll get funding.  If you’re going to use venture capital, then you can’t use an S Corporation, because a venture capital firm cannot be an owner.  Venture capital firms and other professional investors are also sometimes leery of LLCs and partnerships because of the flow-through nature of taxes.  In these flow-through entities, the owners are taxed on earnings whether they receive those earnings as dividends or not.

Are you planning for an IPO, ever?  If so, you’ll almost certainly have to form a C Corporation.

I short, think about how your business will be structured; how many owners will it have?  How big are you planning to get?  Who will the owners be?  Where will you get financing?  Do you need protection of your personal assets?

Then keep in mind that forming a business one way does not make it set in stone.  Your business can change its form many times.  So for now, think about what your business is today, and what you think it will be in the next few years, and set your business up in the way that works best for you and the other owners.

 

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