Dec
03

Entrepreneurial Growth Learning Module F

Learning Module F

Legal Forms of Organizations

 

When starting a business, one has to decide on form of business to establish. The business’s form determines which income tax return must be filed. The most common forms of business are the sole proprietorship, partnership, corporation, a limited liability company.  Legal and tax considerations affect the selection of a business structure.

Sole Proprietorship:

A sole proprietorship is the simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and owner.  The owner is personally and legally responsible for their actions. All profit or loss from a sole proprietorship belongs to the owner.

Partnership

A partnership is a single business where two or more people share ownership. Each partner contributes to all aspects of the business, money, property, labor or skill, and expects to share in the profits and losses of the business.

Limited Liability Company

A limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.  A limited liability company or LLC is legally distinct and separate from its owners.  The “owners” of an LLC are referred to as “members.” The members can consist of a single individual (one owner), two or more individuals, corporations or other LLCs. An LLC offers its owners both limited personal liability for actions of the business and special tax treatment that may prevent what has been called “double taxation” of the owners’ income.

Corporation:

A corporation is a separate legal entity from the individuals who form it and its owners.  Owners are generally protected from personal liability.  In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock.  When setting up a corporation, it is important to determine between a C corporation, the standard corporation, or the S corporation has elected a special tax status with the IRS.

S Corporation – shareholders report income or loss on their individual income tax return.

An S corporation is a corporation with the Subchapter S designation from the IRS.  An eligible corporation can avoid double taxation by electing to be treated as an S corporation. According to the IRS, S corporations are “considered by law to be a unique entity, separate and apart from those who own it.” This limits the financial liability for which the owner is responsible.

S corporation’s profits and losses can pass through to the owners personal tax return, the business is not taxed itself.

C Corporation – the corporation is taxed separately from the owners.

A C corporation is an independent legal entity owned by shareholders. This means that the corporation as an entity is held legally liable for the actions and debts the business incurs.

Corporations are more complex than other business structures because they tend to have costly administrative fees and complex tax and legal requirements. Because of these issues, corporations are generally suggested for established, larger companies with multiple employees.  For businesses in that position, corporations offer the ability to sell ownership shares in the business through stock offerings.

Small Business Administration – Choosing a Structure

 

Sole Proprietorship

Legal liabilities:  You do not have to take any formal action to form a sole proprietorship. As long as you are the only owner, this status automatically comes from your business activities. To file your Sole Proprietorship complete and file for a certificate of assumed name.   Assumed Name forms are filed with the County Register of Deeds.

Tax issues: Because the owner and the business are one and the same, the business itself is not taxed separately. Tax responsibilities include income tax, self employment tax, estimated tax, social security and medicare taxes, federal unemployment tax, filing information returns for payments to non employees and transactions with other persons.

Advantages:  Sole proprietorships are easy to create, minimally expensive to start, the owner has total control, taxes are only paid once, minimal restrictions on sales, and the tax preparation is not as complicated compared to other business structures.

Disadvantages: Sole proprietorships has added risk of unlimited personal liability, issues of succession, and one cannot deduct losses. Sole proprietorships sometimes have added challenges for raising money and ultimately can be a heavy burden for the sole proprietor.

 

Partnership:

Legal liabilities: To form a partnership,  establish the businesses name and register the business with the state through the Secretary of State’s office. Once the business is registered the appropriate licenses and permits must be obtained.

Tax issues: A partnership must file an “annual information return” to report the income, deductions, gains and losses from the business’s operations, but the business itself does not pay income tax. The business passes any profits or losses to its partners. Partners include their respective share of the partnership’s income or loss on their personal tax returns.  Partnership taxes generally include, annual return of income, employment taxes, and excise taxes.  Partners in the partnership are responsible for several additional taxes, including, income tax, self-employment tax, and estimated tax.

Cost of creation: More expensive than a Sole Proprietorship but less expensive than a corporation.

Advantages: Partnerships are relatively easy to form and have several advantages such as buying and selling agreements and taxes is only paid once.  Partners also have shared financial commitment and can offer complementary skills, incentives, and experience to the business.

Disadvantages: Partnerships do come with some added risk in the form of unlimited liability and division of control.  Also, partners can excuse others without consent of the individuals knowledge. These issues can result in conflicts regarding succession, buying out a partner,, restrictions on sales of interests, other partner’s decisions and Shared Profits.

 

Limited Liability Company

Legal Liabilities:  To form a limited liability company (LLC) first choose a business name then file the articles of organization.  After your business is registered obtain licenses and permits.

Tax issues: Limited liability companies are not taxed as a separate business entity. All profits and losses are passed to each member of the limited liability company. Limited liability companies’ members report profits and losses on their personal federal tax returns.

Cost of creation: Limited liability companies creation is more expensive than a sole proprietorship but is less than or equal to the creation of a corporation.

Advantages: Limited liability companies offer the advantage of (as the name implies) limited liability and managers can be owners.  Other advantages include the tax benefits, free transfer of ownership interests, options of institutional ownership, subsidiaries, and less recordkeeping.

Disadvantages: Limited liability companies can be expensive to set up and have the added hurdle of not being able to raise funds publicly.  Limited liability company laws are not the same in all states and the LLC has a limited life. Self employment taxes are also required.

 

S – Corporation:

Legal liabilities: To file as an S Corporation one must first be filed as a corporation. After the business is considered a corporation, shareholders must sign and file Form 2553 to elect the corporation to become an S Corporation. Once your business is registered, obtain business licenses and permits.  There are also federal and state regulations for hiring employees.

Tax issues:  The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends.  This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation. Corporation may be responsible for income tax, estimated tax, employee tax, and excise tax.

Cost of creation: Corporations are typically the most expensive business structure to create.

Advantages: Corporations are treated like a partnership for tax purposes and get the benefit of losses. If the business is ready it can easily convert to a corporation and ownership can be transferred easier. There are also advantages for tax savings, business expense tax credits, and the owner has an independent life.

Disadvantages: The added risk of creating a corporation is the shareholder maximum capacity and the lack of corporate or partnership owners.  There is only one class of stock for S-corporations and additional limitations on passive income.  Also corporations have stricter operational processes and shareholder compensation requirements.

 

C – Corporation:

Legal liabilities: To form a corporation you’ll need to establish your business name and register your legal name with your state government. To register your business as a corporation, you need to file certain documents, typically articles of incorporation, with your state’s Secretary of State office. Some states require corporations to establish directors and issue stock certificates to initial shareholders in the registration process. Once your business is registered, you must obtain business licenses and permits. There are also federal and state regulations for hiring employees.

 

Tax issues: Regular corporations are called “C corporations” because Subchapter C of Chapter 1 of the Internal Revenue Code is where you find general tax rules affecting corporations and their shareholders.  For federal income tax purposes, a C corporations are recognized as a separate taxpaying entity.  C-corporations may be responsible for income tax, estimated tax, employee tax, and excise tax.  Corporations are required to pay federal, state, and in some cases, local taxes.  In some cases, corporations are taxed twice – first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns.

Cost of creation: Corporations are typically the most expensive business structure to create.

Advantages: C-corporations have no limit on shareholders and limited liability.  Corporations also make available to opportunity for more financing opportunities and the possibility of setting up offshore accounts with better tax benefits.  Owners have the option to be independent from the corporation and they can easily transfer ownership. Corporations have abilities to generate capital, receive corporate tax treatment and attract to potential employees.

Disadvantages: Corporations are subject to more regulation, double taxation, and their losses do not pass through.  Corporations are expensive to create and legally maintain.  There is a lack of ownership control because control is granted to board members.  An additional amount of paperwork, time, and money is required to maintain a corporation.

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