When deciding which entity to form it is necessary to consider short and long term goals of the business, the nature of the business and the benefits associated with each type of entity. The different types of business entities are:
Sole Proprietorship, which you are by default, until you set up a formal business entity, is a business in which one person owns all the assets, owes all liabilities, and operates in their personal capacity. The advantages are that no formalities are required in either formation or operation and the business acts as a pass-through entity for tax purposes, thereby eliminating the double tax on business profits. The disadvantages are that a sole proprietorship offers no shield from liability and cannot claim certain tax breaks available to other types of business entities.
Corporations are business entities having authority under the law to act as a wholly separate entity from its owners. Pursuant to state law, corporations have the rights to exist indefinitely and to issue equity interests in the business, which is called stock. The owners of the corporation, called shareholders, create rules, or “Bylaws,” by which the corporation must operate.
Partnerships are voluntary association of two or more persons who jointly own and carry on a business for profit. Each partner is equally liable for acts and omissions of the business and each shares equally in the income, unless otherwise agreed by the partners in a partnership agreement. There are three forms of partnerships: general partnerships, limited partnerships and limited liability partnerships. The primary difference between them is that the latter two each have one “general partner,” who is liable for everything, and other “limited partners,” whose liability is limited to certain amounts.
Limited Liability Company, or LLC is not a partnership or a corporation. An LLC is a distinct type of business that offers an alternative to partnerships and corporations, by combining the corporate advantages of limited liability with the partnership advantage of pass-through taxation.
Forming a business entity serves four purposes:
- Protects you as a Business Owner. Certain types of business entities, including corporations and limited liability companies, if properly established and operated, are distinct from their owners. Therefore, when made with a legitimate purpose, actions that you take on behalf of your business, won’t expose you or your shareholders to liability for any debt incurred by the business. Personal liability of the shareholders is normally limited to the amount of money invested in the corporation.
- Saves you Money on Taxes. Depending on the size, profitability, and expenses of your business, you can save money on your taxes by choosing an appropriate business entity. A corporation can be structured in different ways to provide you with substantial tax savings. You can minimize self-employment taxes and increase the number of allowable deductions lowering the taxes you pay on the income of the business. Many corporations structure retirement and tax deferred savings plans for their owners and employees which can provide even greater tax savings.
- Structured Business Operations. Certain business entities require the enactment of provisions providing for internal governance of the business entity. These provisions (bylaws for corporations, partnership agreements for partnerships, and operating agreements for limited liability companies) provide structure to the business entity and prevent disputes between owners.
- Projects a Professional Image A properly formed and operated business entity projects a professional image. You will gain consumer confidence in your business and your products and services.