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In today’s competitive landscape, choosing the right legal structure for your business is paramount for success. Keeping your home-based business legal involves choosing its legal structure: sole proprietorship, partnership, or corporation. The structure you opt for impacts your taxes and dictates your liability, governance, and compliance requirements. This is necessary for government reporting and tax purposes and can enable your business to operate more efficiently. Since each legal form has unique characteristics, your goal is to choose the best form for you.
Let’s delve into the various business structures to help you make an informed decision.
Table of Contents
Sole Proprietorship
A business owned by one person, entitled to all its profits and responsible for all its debts, is considered a sole proprietorship. This legal form is the simplest, providing maximum control and minimum government interference. Currently used by over 75 percent of all businesses, it is often the suggested way for a new business that does not carry great personal liability threats. The owner must secure the necessary licenses, tax identification numbers, and certifications in his or her name, and you are now in business!
Advantages of Sole Proprietorship | Disadvantages of Sole Proprietorship |
---|---|
Easy to Establish: Sole proprietorships are easy and inexpensive to set up, requiring minimal formalities and paperwork. | Unlimited Liability: The owner is personally liable for all debts and liabilities of the business, which can put personal assets at risk. |
Full Control: The owner has complete control over decision-making and operations, allowing quick decision-making. The owner keeps all profits. | Limited Growth Potential: Sole proprietorships may face limitations in growth potential due to limited resources and expertise. |
Simplified Taxation: Income from the business is reported on the owner’s personal tax return, simplifying tax filing requirements. | Lack of Continuity: The business ceases to exist if the owner dies or decides to sell or close the business, leading to potential continuity issues. |
Full Control: The owner has complete control over decision-making and operations, allowing for quick decision-making. The owner keeps all profits. | Difficulty in Raising Capital: Sole proprietors may find it challenging to raise capital since they rely solely on personal funds or loans. |
Privacy: There is no requirement to disclose financial information publicly, offering privacy for the owner. | Limited Expertise and Resources: Sole proprietors may lack access to specialized skills and resources needed to compete effectively in the market. |
Ease of exit: You can discontinue your business at will. | Flexibility: Sole proprietors can adapt quickly to changing market conditions and customer demands. |
The main advantages that differentiate the sole proprietorship from the other legal forms are (1) the ease with which it can be started, (2) the owner’s freedom to make decisions, and (3) the distribution of profits (the owner takes all).
Still, the sole proprietorship has disadvantages, the most serious of which is its unlimited liability. As a sole proprietor, you are responsible for all business debts. Should these exceed the assets of your business, your creditors can claim your assets–home, automobile, savings account, and investments. Sole proprietorships also have more difficulty obtaining capital and retaining key employees. This stems from the fact that sole proprietorships generally have fewer resources and offer fewer opportunities for job advancement. Thus, anyone who chooses sole proprietorship should be prepared to be a generalist, performing various functions, from accounting to advertising.
Partnership
A business owned by two or more people who agree to share in its profits is considered a partnership. Like sole proprietorships, partnerships are easy to start and involve minimal red tape. The tax structure is the same as proprietorships, except that the partners divide the partnership’s profits and losses by an agreed-upon percentage.
Advantages of Partnership | Disadvantages of Partnership |
---|---|
Shared Responsibility: Partnerships allow for the distribution of responsibilities among multiple individuals, reducing the burden on one person and leveraging each partner’s strengths. | Unlimited Liability: In a general partnership, partners are personally liable for the debts, obligations, and liabilities of the business, which means their personal assets may be at risk. |
Combined Resources: Partnerships pool together the financial resources, expertise, and networks of multiple individuals, enabling the business to access a broader range of resources than would be available to a sole proprietorship. | Limited Growth Potential: Partnerships may face limitations in growth and expansion, particularly if partners have differing visions for the business or disagreements on strategic direction. |
Unlimited Liability: In a general partnership, partners are personally liable for the business’s debts, obligations, and liabilities, which means their personal assets may be at risk. | Shared Profits: Profits generated by the business are shared among the partners according to the terms of the Partnership Agreement, which may lead to disagreements over distribution or compensation. |
Shared Decision-Making: Decisions are made collectively among the partners, allowing for different perspectives to be considered and potentially leading to more well-rounded and informed choices. | Limited Growth Potential: Partnerships may face limitations in terms of growth and expansion, particularly if partners have differing visions for the business or if there are disagreements on strategic direction. |
Tax Advantages: Partnerships typically pass through profits and losses directly to the partners, avoiding double taxation at both the entity and individual levels. | Shared Decision-Making: Decisions are made collectively among the partners, allowing for different perspectives to be considered and potentially leading to more well-rounded and informed choices. |
The main advantages of the partnership form are that the business can (1) draw on the skills and abilities of each partner, (2) offer employees the opportunity to become partners, and (3) utilize the partners’ combined financial resources. It is also fairly simple and inexpensive to set up, making going into business with family and friends easy. Because two or more people are putting their assets together in a partnership, borrowing power is greater. Capitalizing a business is simpler and stronger when many people combine their resources. Each partner also has the unique opportunity to specialize in their expertise.
Partnerships also have their share of disadvantages. The unlimited liability to a sole proprietorship is even worse for partnerships. As a partner, you are responsible not only for your business debts but also for your partners. Should they incur debts or legal judgments against the business, you could be held legally responsible for them. Disputes among partners can be a problem, too. Unless you and your partners see eye to eye on how the business should be run and what it should accomplish, you are in for trouble.
For your protection, it is advisable to have a written partnership agreement that will spell out the specifics of the agreement. At the time of the formation of the partnership, an agreement should be drawn up stating the percentage of shares each partner owns, the conditions under which shares can be disposed of, and in what manner. This should state
- Each partner’s rights and responsibilities,
- The amount of capital each partner is investing in the business,
- The distribution of profits,
- What happens if a partner joins or leaves the business,
- How are the assets to be divided if the business is discontinued?
The agreement can be modified later upon the approval of a majority. If there are problems between partners, the agreement is the legal document that they should be able to use to fall back on. Things have a way of changing, and people forget over time, so there must be a signed document that all abide by. Unless otherwise stated in an agreement, the partnership must be dissolved upon the death of a partner. In contrast, the remaining partners must purchase or inherit the deceased partner’s shares unless otherwise stated in a succession agreement.
However, a partnership is generally the least advisable way to go. It requires filing a separate partnership tax return, does not carry liability protection for general partners, and can lead to legal and personal disputes. A corporate form of ownership is generally preferred over a partnership because it can serve the same purpose while offering owners a cleaner and better-protected structure. In a partnership, all partners are at risk for liabilities, and all assets are at risk in a limited partnership. In addition, if a partner wants to leave the partnership, the remaining partner may suffer financial loss.
Corporation
A corporation differs from the other legal forms of business in that the law regards it as an artificial being possessing the same rights and responsibilities as a person. This means that, unlike sole proprietorships or partnerships, it has an existence separate from its owners. It has all the legal rights of an individual in regards to conducting commercial activity — it can sue, be sued, own property, sell property, and sell the rights of ownership in the form of exchanging stock for money.
Advantages of Corporations | Disadvantages of Corporations |
---|---|
Limited Liability: Shareholders of a corporation enjoy limited liability, meaning their personal assets are protected from the debts and liabilities of the business. Their liability is generally limited to the amount of their investment in the corporation. | Double Taxation: C corporations are subject to double taxation, meaning the corporation’s profits are taxed at the corporate level, and then any dividends distributed to shareholders are taxed again at the individual level. This can result in higher overall tax burdens. |
Perpetual Existence: Corporations have perpetual existence, meaning they can continue to exist even if ownership changes or shareholders pass away. This provides stability and continuity for the business. | Limited Control: Shareholders in a corporation may have limited control over the business’s day-to-day operations, as management is typically delegated to a board of directors and executive officers. This can lead to conflicts between shareholders and management. |
Access to Capital: Corporations have various avenues for raising capital, including issuing stocks and bonds. This allows them to attract investment from a wide range of investors and potentially raise significant amounts of capital for expansion or investment. | Complex Structure and Compliance: Corporations are subject to more complex legal and regulatory requirements compared to other business structures. They must comply with state incorporation laws, maintain detailed corporate records, hold shareholder meetings, and fulfill various reporting and filing obligations. |
Transferability of Ownership: Ownership interests in a corporation, represented by shares of stock, are easily transferable. Shareholders can buy, sell, or transfer their shares without affecting the corporation’s operations. | Cost of Formation and Maintenance: Establishing and maintaining a corporation can be more costly and time-consuming than other business structures due to legal fees, filing fees, and ongoing administrative expenses. |
Tax Flexibility: Depending on its structure, a corporation can choose different tax treatments, such as being taxed as a C corporation or an S corporation, providing flexibility in tax planning and management. | Public Scrutiny: Publicly traded corporations are subject to heightened scrutiny from shareholders, regulators, and the public. They must disclose financial information and adhere to corporate governance standards, which can sometimes attract unwanted attention or legal challenges. |
As a result, the corporation offers some unique advantages. These include (1) limited liability: owners are not personally responsible for the debts of the business, (2) the ability to raise capital by selling shares of stock, and (3) easy transfer of ownership from one individual to another. Plus, unlike the sole proprietorship and partnership, the corporation has “unlimited life” and thus the potential to outlive its original owners.
The main disadvantages of the corporate form can be summed up in two words: taxation and complexity. In what amounts to double taxation, you must pay taxes on both the income the corporation earns and the income you earn as an individual. Along with this, corporations are required to pay an annual tax on all outstanding shares of stock. Given its complexity, a corporation is more difficult and expensive to start than a sole proprietorship and a partnership.
To form a corporation, you must be granted a charter by the state of your home-based business. The cost of incorporating a small business usually ranges from $500 to $1,500. This includes the costs for legal assistance in drawing up your charter, state incorporation fees, and the purchase of record books and stock certificates. Since corporations are subject to closer government regulation, the owners must bear the ongoing cost of preparing and filing state and federal reports.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a business structure that combines the limited liability protection of a corporation with the flexibility and tax benefits of a partnership or sole proprietorship. In an LLC, owners are called “members,” an operating agreement governs the company’s operations. Depending on their preferences, LLCs can be taxed as sole proprietorships, partnerships, or corporations.
Advantages of Limited Liability Company (LLC) | Disadvantages of Limited Liability Company (LLC) |
---|---|
Limited Liability Protection: Members’ personal assets are typically protected from business debts and liabilities, reducing personal risk. | Limited Life Span: In some jurisdictions, the life of an LLC may be limited, especially if there are changes in membership or management. |
Pass-through Taxation: Profits and losses “pass-through” the LLC and are reported on the members’ personal tax returns, avoiding double taxation. | Self-Employment Taxes: Members may be subject to self-employment taxes on their share of LLC profits. |
Flexible Management Structure: LLCs can be managed by members or appointed managers, allowing for a customized management structure. | Complexity: Setting up and maintaining an LLC may involve more paperwork and administrative requirements compared to a sole proprietorship or partnership. |
Operational Flexibility: LLCs have fewer formalities and regulations than corporations, offering more flexibility in decision-making and operations. | Limited Investment Opportunities: Raising capital through the sale of shares is more complex for LLCs than corporations. |
Credibility and Perpetual Existence: Operating as an LLC can enhance credibility with customers, vendors, and partners, and LLCs can typically continue to exist beyond the departure of members. | Limited Investment Opportunities: Raising capital through the sale of shares is more complex for LLCs compared to corporations. |
State-Specific Regulations: LLCs are subject to state-specific regulations, which may vary in filing requirements, taxes, and reporting obligations. | State-Specific Regulations: LLCs are subject to state-specific regulations, which may vary in terms of filing requirements, taxes, and reporting obligations. |
Limited Liability Companies (LLCs) offer several advantages, including limited liability protection for members, flexible taxation options, and a less formal management structure. However, this business structure also has notable disadvantages.
One primary disadvantage is the potential for members to face self-employment taxes on their share of profits, which can result in higher tax burdens than other entities. Additionally, the formation and operational requirements of an LLC can be complex, often requiring legal and financial assistance, which can lead to higher initial costs. Another drawback is the limited lifespan of an LLC, especially in jurisdictions where changes in membership or management can impact its continuity.
Moreover, while LLCs offer some flexibility in raising capital, they may face limitations compared to corporations, particularly in accessing capital through stock sales. Despite these disadvantages, many businesses still choose LLCs for their combination of liability protection, taxation flexibility, and management simplicity. Still, carefully considering these drawbacks is essential when selecting a business structure.
Read the articles:
- Everything You Need to Know About LLC
- Choosing an LLC Structure for Your Business
- S Corporation vs. LLC: Which Structure is Right for Your Business
S Corporation
If you are interested in forming a corporation but hesitate to do so because of double taxation, there is a way to avoid it. You can do this by making your business an S corporation. The Internal Revenue Service permits this type of corporation to be taxed as a partnership rather than a corporation. However, to qualify for S status, your business must meet the specific requirements set forth by the IRS. These include limits on (1) the number and type of shareholders in the business, (2) the stock that is issued, and (3) the corporation’s sources of revenues.
Advantages of S-Corporations | Disadvantages of S-Corporations |
---|---|
Tax Savings: Shareholders can avoid self-employment taxes on their share of the profits, potentially resulting in tax savings. | Stricter Operational Requirements: S Corporations are subject to stricter operational requirements, such as regular meetings, minutes maintenance, and compliance with state regulations. |
Limited Liability Protection: Shareholders are typically not liable for the debts and obligations of the corporation beyond their investment. | Eligibility Restrictions: S Corporations have strict eligibility criteria, including a limit on the number of shareholders and the requirement that all shareholders must be U.S. citizens or residents. |
Pass-Through Taxation: Profits and losses “pass-through” to shareholders, avoiding double taxation at both the corporate and individual levels. | Limited Stock Options: S Corporations cannot have more than one class of stock, limiting their flexibility in raising capital. |
Credibility and Prestige: Being an S Corp may enhance a company’s credibility with customers, suppliers, and partners. | Potential for IRS Scrutiny: S Corporations may face scrutiny from the IRS to ensure compliance with regulations, particularly regarding reasonable compensation for owners. |
Easy Transfer of Ownership: Ownership interests in an S Corporation can be easily transferred without affecting the corporation’s operations | Limited Growth Potential: S Corporations may face limitations in growth due to the restrictions on shareholders and stock classes. |
Entrepreneurs considering forming any of these business legal structures should carefully weigh the advantages and disadvantages against their specific business needs and goals. Consulting with legal and financial professionals can help make informed decisions regarding business structure.
Recommended Books on Legal Structure
- The perfect business structure handbook: Proper business structure for entrepreneurs & small businesses. (The Faithful Wealth)
- The Only LLC Beginners Guide You’ll Ever Need: Limited Liability Companies For Beginners – Form, Manage & Maintain Your LLC (Starting a Business Book) (How to Start a Business)
- Nolo’s Guide to Single-Member LLCs: How to Form & Run Your Single-Member Limited Liability Company
- The Only S-Corp Beginner’s Guide You’ll Ever Need: A Roadmap on Starting & Managing Your S Corp: Plus Bookkeeping & Accounting Tips to Reduce Small Business Taxes (How to Start a Business, Book 2)
- The Legal Side to Starting a Business for Beginners: How to Choose between an LLC and Corporation, Set up Agreements with Partners and Contractors, … Property (How to Start a Business Series)
Article originally published on August 25, 2012 and updated on March 27, 2024.
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It is an excellent article.One of the first decisions that you will have to make as a business owner is how the company should be structured. This decision will have long-term implications, so consult with an accountant and attorney to help you select the form of ownership that is right for you.
Choosing the Legal Structure of Your Business
Thanks for the great article.There are many things I have flat know from your posts.Thank you very much.
regards.
bizworldusa
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