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The right business structure can save you from liability, support your business goals and save you money at tax time. But how do you decide? Here’s a quick guide to some of the most common business forms.
One of the first tasks a new business owner faces is choosing a company structure. But when confronted with an array of similar-sounding options, it’s easy to feel confused.
How do you compare business structures and determine which one is best? Let’s take a look at the advantages and disadvantages of some of the most common business types.
For a solo entrepreneur or husband and wife, an individual entrepreneur 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 tax return.
The downside is, that sole proprietors are not legally separated from their businesses, so they are liable for all of their business’s responsibilities. That means a sole proprietor’s bank accounts, house, and cars are at stake in a lawsuit against the business.
An individual entrepreneur is best suited to a business possessed by an individual or couple that does not have employees or sign agreements with landlords, vendors, suppliers, or subcontractors.
A business with two or more owners that have not selected 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 a penalty for their partners’ negligence or misconduct. And, all too often, associates 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 company 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.
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Businesses that choose to be limited partnerships typically have external investors who aren’t involved in the day-to-day business processes. However, an LLC is a better choice for many companies 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 attorneys 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, delivers its owners (known as “members”) with protection against liability for company obligations. So, if your LLC can’t pay its obligations or is unable to meet its obligations, only the business assets—and not the partners’ assets—are at risk in a lawsuit. Members remain liable for their failure 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 associates.
This flexibility and limited liability make LLCs a favored 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 corporation. In addition, LLCs are a relatively new company 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 rather more complex recordkeeping and reporting requirements than LLCs, relying on the state in which they incorporate.
Corporate shares are easy to transfer from one person to another. This can be necessary if you want to attract outside economic support or give shares to employees or people who helped with your startup. Many outside investors strongly prefer to invest in companies.
If your business is designed to help others or support a cause rather than to make a profit for its proprietors, you may want to establish a nonprofit corporation. Nonprofit corporations have the same liability shield as for-profit corporations.
Once you’ve formed a nonprofit corporation with your region, you must still apply for tax-exempt status. 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 an individual entrepreneur or general partnership, you’ll need to file paperwork with the state to establish your chosen business entity.
Every business that’s not an individual entrepreneur requires 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 valuable investment that can save you a lot of money and stress in the future.