April 02, 2014

Types of Businesses

Credit: pakorn
Have you ever looked at someone’s business card and wondered what the “LLC” or “LLP” meant? Perhaps you’ve thought about starting your own business and wondered what type of business entity you should be. Maybe you’ve been curious about the differences between a C Corporation and an S Corporation but have never taken the time to find out. Look no further, as I’d like to briefly go over the similarities and differences among many of the most common types of businesses.
  • Sole Proprietorship: A sole proprietorship is the simplest and most common structure chosen to start a business. This type of entity is an unincorporated business that is owned and run by an individual or an individual and his or her spouse. Setting up a sole proprietorship may require some licenses and permits, but it is relatively simple to start, usually inexpensive to form, and the tax implications from any income or expenses generated by such a business are simply part of the owner’s individual tax return (Form 1040) on Schedule C. A major downside of sole proprietorships is that there is no separation between the owner and the business, so an owner would be personally liable for any and all debts incurred by the business.
  • Partnership: A partnership is a business owned by two or more people who are usually not spouses. Each partner contributes something to the business, such as property, money, or labor, in return for a share of the profits (or losses) generated by the business. There are two types of partnerships: a general partnership, where all profits, liabilities, and management duties are split by all of the partners, or a limited partnership, where one or more general partners manage the business and share fully in its profits and losses while one or more limited partners share in the profits of the business, but their personal risk of loss is limited to the extent of their investment. Partnerships require formal registration, and it’s usually best if a legal partnership agreement discussing how the partners will divide profits, resolve disputes, change ownership, and dissolve the partnership is in place before operations begin. Still, it’s a relatively easy and inexpensive way to set up a business. Partnerships have their own required tax returns (Form 1065), and those returns generate informational statements called K-1s that are given to each partner so that they can report their share of profits, losses, and expenses on their own personal tax returns.
  • C Corporation: A C Corporation is a separate legal entity owned by its shareholders. Corporations are usually more complex and costly to form as they require formal registration, articles of incorporation, licenses, permits, and state applications. A C Corporation addresses several of the shortcomings of sole proprietorships and partnerships in the sense that shareholders' personal assets are protected from liability and only subject to losses equal to their investment in the corporation. Additionally, C Corporations can more easily raise additional capital by selling shares of stock in the company. C Corporations have their own required tax returns (Form 1120), and corporate income tax rates are often lower than individual income tax rates, but it’s important to realize that C Corporation income can actually be taxed twice, first at the corporate level and second at the individual shareholder level if the company pays out some of its profits to its shareholders (dividends).
  • S Corporation: An S Corporation is a special type of corporation created by making an IRS election. An S Corporation election can be valuable to its shareholders because it allows for company profits, losses, and expenses to be taxed on their personal individual tax returns and avoids the double taxation C Corporations often generate for their shareholders. Making an S Corp election should be carefully considered, as the IRS does not offer this election or allow a company to keep this election unless they follow strict operational processes, limit the number of shareholders, and reasonably compensate their shareholders. It’s also worth mentioning that an S Corporation does not offer quite as strong of liability protection in some areas as a C Corporation does for its shareholders. 
  • Limited Liability Company (LLC)/Limited Liability Partnership (LLP): An LLC is a hybrid type of legal entity that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a sole proprietorship or partnership. An LLC requires a lot of the complex registration and initial set-up requirements similar to that of a corporation, but the increased liability protection and “pass-through” taxation like that of a sole proprietorship or partnership makes this type of entity highly desirable to many entrepreneurs. An LLP is a lot like an LLC and similar to a general partnership, except partners do not have personal liability for the negligence of other partners.
What type of entity should a business be? It depends. Personal liability protection, tax implications, and the desires and goals of the founder or founders should dictate.

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