A fundamental question an entrepreneur must answer when starting a small business is what kind of ownership structure the business will have. There are three basic forms of business ownership: sole proprietorship, partnership and corporation. Each of these forms of business organization has advantages and disadvantages in such areas as setting up the company, paying taxes and assessing liability for business debts.
Choosing a Sole Proprietorship
A sole proprietorship is a business owned by a single individual or, in some cases, a married couple. The chief advantage of the "sole prop" is simplicity. There's no paperwork to set one up because you quite literally are the business.
There's no legal separation between you and the company. This means the business's profits are your profits, the business's debts are your debts and the business's income is taxed as your personal income.
That lack of separation is also the chief disadvantage of a sole proprietorship: You are personally responsible for all of the debts, taxes and other financial obligations of the business, including legal judgments. This is known as having "unlimited liability."
Choosing a Partnership
A partnership is a company jointly owned by two or more people whose ownership shares, rights and responsibilities should be spelled out in a partnership agreement. Partnerships also have the benefit of simplicity. Beyond the partnership agreement, there's little paperwork involved.
Like sole proprietorships, partnerships don't pay income taxes themselves. Instead, they file a tax return showing how much profit they made, if any, and then the partners pay taxes on that profit as personal income. Partners will be taxed on the profit regardless of whether they actually received that profit in cash. Even if the money was reinvested in the firm, they still have to pay taxes on it. In any partnership, at least one partner must be a "general partner" who has unlimited liability for the business's debts.
Forming a Corporation
A corporation is a business owned by shareholders. This form of business ownership protects its owners with "limited liability." That means you can lose the money you invest in the company, but beyond that, debts and other financial obligations belong to the corporation, not to the owners.
That's the key advantage of incorporating. On the downside, corporations must pay income taxes on their profits. Any profits distributed to the owners as dividends get taxed again as the owners' personal income, meaning corporate profits are subject to "double taxation."
Incorporating also involves legal formalities, including filing articles of incorporation with the state, following the corporate requirements of the state of incorporation and issuing stock, even if you're the only shareholder.
Alternatives in Business Formation
Business owners have some alternatives that blend the most advantageous features of the three main business structures. Every state allows for "limited liability companies" or LLCs. These are businesses that essentially operate like sole proprietorships or partnerships but enjoy the liability protection of corporations.
Federal tax law and many state tax codes also provide for a special kind of corporation, known as an S corporation, that enjoys limited liability protection but that doesn't pay corporate income taxes. Instead, it gets taxed like a partnership.
Not just any corporation can be an "S corp," though. This structure is designed for small businesses, so there are limits on how many shareholders an S corp can have and who those shareholders can be.
Consulting with legal and accounting professionals is important for understanding the advantages and disadvantages of business ownership types for your type of business and personal financial situation.
