Choosing an organization type for your business

One of the most important of all the choices you make when starting a business is the type of legal organization you select for your business. The organization type you choose for your business will have effects in many ways. You have to think carefully about your business and personal needs. It is recommended that you consult a tax expert or an attorney. 

A structure that makes the most sense to your business depends on the individual circumstances of each business owner. The following are several factors to be considered in choosing what structure of organization you want your business to be:

• How income is taxed
• The level of personal liability risk you face
• The importance of borrow money
• The amount of paperwork your business is required to do (record keeping requirements)
• Initial costs

After considering the factors above and depending on your needs, you will find that one type of organization will probably better suit your business than the others. You can generally reorganize your business into a more suitable type, if it outgrows one organization type. 

The most common forms of businesses are:

• Sole Proprietorships
• Partnerships
• Corporations
• Limited Liability Companies (LLC)

Business formation is controlled by the law of the state where your business is organized. While state law controls the formation of your business, federal tax law controls how your business is taxed.  Federal tax law recognizes an additional business form, the Subchapter S Corporation.

As for tax purpose, all businesses must file an annual return.  The form you use depends on how your business is organized.  Sole proprietorships and corporations file an income tax return.  Partnerships and S Corporations file an information return.  For an LLC with at least two members, except for some businesses that are automatically classified as a corporation, it can choose to be classified for tax purposes as either a corporation or a partnership. A business with a single member can choose to be classified as either a corporation or disregarded as an entity separate from its owner, that is, a “disregarded entity.”  As a disregarded entity the LLC will not file a separate return instead all the income or loss is reported by the single member/owner on its annual return.

Next we provide a quick look at the differences between the most common forms of business entities.

Sole proprietorship

This is the easiest and least expensive method of setting up a new business. However, you have no personal liability protection, meaning that you are personally liable for the actions of your business. In terms of taxation, a sole proprietorship offers both advantages and disadvantages as compared to other forms of organization. Income from a sole proprietorship flows through to you, the owner, and is taxed as your own personal income. This keeps taxation relatively simple. On the other hand, a sole proprietorship must pay self-employment tax on top of personal income tax. Also, unlike with other forms of business such as a corporation, certain business tax deductions may be limited.

Partnership

A partnership is basically the same as a sole proprietorship except it has more than one owner. While essentially true, this basically understates the ramifications of choosing to share ownership. Combining your resources with a partner can make it easier to get your business off the ground, but it also complicates matters in many important ways. If you form a partnership, you become personally liable for the business decisions your partner makes. If your partner starts engaging in bad business deals and then leaves town, you will be left holding the bag. There are also other negative consequences to forming a partnership. It is very easy to get into a partnership, but if things don't work out or if a partner dies, getting out of it can be expensive and time-consuming.

Similar to a sole proprietorship, income in a partnership flows through to the individual partners and is taxed as personal income at their individual tax rates. Partners report income to the IRS by filing Schedule K-1.

Partnerships work best in situations where two people need to pool their resources to acquire an asset such as a building. 

When forming a partnership, it is strongly recommended you hire a lawyer to draft the agreement. As part of the process, sit down with your partner and try to come up with every possible scenario, both good and bad, that could affect the business, and then put it all in writing.

Limited Partnerships (LPs) & Limited Liability Partnership (LLPs)

Limited Partnerships (LPs) differs in one significant way from a normal partnership in that it allows for two types of partners. There are general partners who are considered the owners and managers. Then there are limited partners who are not involved in the day-to-day business and have only a limited liability. This form of organization is often used when there are individuals who want to invest money in a business, but don't want to run it. These people become limited partners and, unlike the general partners, they generally are not liable for more than their investment in the business.

A Limited Liability Partnerships (LLPs) is similar to a Limited Partnership, but it has no general partners. All of the owners of an LLP have limited personal liability for business debts. As a result, LLPs are more suited for businesses where all investors wish to take an active role in management.

Corporation

The corporation is fundamentally different from other types of businesses. Instead of having a distinct owner, a corporation is owned by at least one shareholder and run by the shareholders and at least one director. Because the corporation itself is considered a legally separate entity from the shareholders, the shareholders generally cannot be held personally responsible for the actions of the corporation. The other big advantage is that the corporate structure generally makes it easier to raise money. However, it is much more expensive and complicated to set up and manage a corporation. The other disadvantage is that corporate profits currently are generally taxed twice: once at the corporate level and once at the personal level level. 

There are two types of corporations, the regular C-Corporation and the S-Corporation. Unlike a C-Corporation where earnings are currently generally taxed at both the corporate and individual levels, earnings at an S-Corporation flow through to the individual and are only taxed at the individual shareholder level. In other words, if, as the owner of the business, you are the only shareholder, all earnings your S-Corporation makes will be taxed at your personal income tax rate. You can avoid being doubly taxed. On the downside, S-Corporations are limited to a smaller number of shareholders. If you want a structure that better supports large numbers of shareholders, you're better off organizing as a C-Corporation. 

Limited liability company (LLC)

This type of organization typically combines the liability protection of a corporation with a tax structure similar to that of a partnership. As with a corporation, there is more legal separation between you and your business than with other types of organization; this offers greater liability protection of your personal assets. As with a partnership, generally income is only taxed once, as personal income. The disadvantage relative to a partnership is that a LLC is more expensive and more difficult to set up.

Depending on where you plan on conducting business, another disadvantage of LLCs is that some states impose special taxes.

If you decide to form a corporation, LLC, or nonprofit, Intuit has partnered with Business Filings Incorporated to offer affordable online filing services.