For a solo entrepreneur or husband and wife, a sole proprietorship is the simplest type of business. You don’t need to do anything to set one up and you’ll report your business income on your personal tax return.
The downside is, sole proprietors are not legally separate from their businesses, so they are liable for all of their business’s obligations. That means a sole proprietor’s bank accounts, house, and cars are at risk in a lawsuit against the business.
A business with two or more owners that has not established an entity is automatically treated as a general partnership. General partners typically share the management of the business and its profits and losses.
However, like a sole proprietorship, a general partnership does not shield its partners from liability for business obligations.
Lawyers tend to advise against operating as a general partnership because general partners don’t have any protection against liability for their partners’ negligence or misconduct. And, all too often, partners neglect to sign a formal partnership agreement, leading to costly disputes later on.
A limited partnership has two tiers of partners: at least one general partner who is actively involved in operating the business and is personally liable for business obligations, and at least one limited partner who is not involved in running the business. The limited partner shares in the business profits but his or her liability is limited to the amount invested in the business.
Businesses that choose to be limited partnerships typically have outside investors who aren’t involved in the day-to-day business operations. However, an LLC is a better choice for many businesses because it offers limited liability in addition to management by a select group.
Limited liability partnership
A limited liability partnership is similar to a general partnership, but the partners are protected from responsibility for the other partners’ negligence. LLPs are often used by professionals such as lawyers and accountants who don’t want to be liable for their partners’ malpractice. In some states, these professionals are not allowed to form corporations or LLCs.
Limited liability company
As the name suggests, a limited liability company, or LLC, provides its owners (known as “members”) with protection against liability for company obligations. So, if your LLC can’t pay its debts or is unable to meet its obligations, only the business assets—and not the members’ personal assets—are at risk in a lawsuit. Members remain liable for their own personal negligence or wrongdoing.
LLCs are flexible in that they can be taxed in the same way as a sole proprietorship or partnership, or they can elect to be taxed as a corporation. LLCs can be managed by their members, or they can be managed by people designated as managers. And an LLC can have one member or many members.
This flexibility and limited liability make LLCs a popular choice for small businesses of all types. LLCs also have fewer recordkeeping, meeting, and reporting requirements than corporations.
However, an LLC is not a good choice if you plan to seek venture capital or angel investors, or if you plan to become a publicly-traded company. In addition, LLCs are a relatively new business type, and there is less formal guidance and legal precedent available for LLCs than for corporations.
Corporations offer their owners (called “shareholders”) the same liability protection as LLCs. Corporations tend to have somewhat more complex recordkeeping and reporting requirements than LLCs, depending on the state in which you incorporate.
Corporations may be taxed as “C corporations” or “S corporations.” A C corporation pays corporate income tax, and its shareholders also pay taxes on the money they bring home. S corporations do not pay tax at the corporate level: business income flows through to the shareholders’ personal returns. An accountant can advise you on the best tax status for your business.
Corporate shares are easy to transfer from one person to another. This can be important if you want to attract outside financial support or give shares to employees or people who helped with your startup. Many outside investors strongly prefer to invest in corporations.
If your business is designed to help others or support a cause rather than to make a profit for its owners, you may want to establish a nonprofit corporation. Nonprofit corporations have the same liability protection as for-profit corporations.
Once you’ve formed a nonprofit corporation with your state, you must still apply for tax-exempt status from the Internal Revenue Service. To be tax-exempt, you must, among other things, use profits toward managing your business or charity and not pay dividends to shareholders.
Unless you’re a sole proprietorship or general partnership, you’ll need to file paperwork with the state to establish your chosen business entity.
Every business that’s not a sole proprietorship needs a written document that provides guidelines on how your business will make decisions, accept new owners, resolve disputes and deal with departing owners. The document may be called a partnership agreement, operating agreement, or bylaws, but whatever the name, it’s a worthwhile investment that can save you a lot of money and stress in the future.