First Steps to Establishing Your New Business: Choosing the Right Business Structure for You, Part I

Turning your business idea into reality can be exciting and gratifying. Before you get started, however, you need to decide how your new venture will be structured. Your choice will determine how your business is owned, operated and taxed.

The structure you choose will also determine your potential personal liability for business debts. This is why most people hire an attorney from the outset.

What if I don’t officially form a business entity?

If you do not establish a formal business structure, your business will be considered a sole proprietorship (one owner) or a general partnership (two or more owners).

  • With a sole proprietorship, you and your business are the same – your business income is taxed at your individual tax rate and is reported on your personal income tax return. On the downside, if you have business debts that you cannot pay and/or your business is sued, your home and personal bank account could be at risk.
  • Although not required, general partnerships benefit from a written partnership agreement that clearly sets forth rules for decision-making on behalf of the business – particularly since every partner not only shares the profits, but is also personally liable for the entirety of the partnership’s debts.

Note that even without a formal entity, you still need to acquire the necessary licenses and permits.

What options can provide limited liability?

To limit their liability, many people structure their business as a corporation, limited liability company (LLC), limited partnership (LP) or limited liability partnership (LLP). These business entities enable their owners to protect their personal assets and limit their losses to what they invested in the company.

The most common types of corporation are “S” and “C” corporations:

  • The income, losses, credits and deductions of an S corporation pass through to its shareholders, who report the income and losses on their personal tax returns and pay tax at their individual income tax rates. Note that not all corporations are eligible to elect S corporation status, and none of the corporation’s shareholders may be non-resident aliens, corporations or partnerships. The number of S corporation shareholders is limited to 100.
  • With a C corporation, there are two levels of taxation: (1) corporate income tax and (2) personal income tax on each shareholder’s corporate dividends. Despite the double taxation, a C corporation has some benefits, including the ability to reinvest corporate profits at a lower corporate tax rate, and to offer shares of stock that could generate capital for corporate growth. There is no limit to the number of shareholders permitted by a C corporation, but registration with the Securities and Exchange Commission (SEC) is required upon reaching specific thresholds.

In our next post, we will review the limited liability company (LLC), the limited partnership (LP), and the limited liability partnership (LLP).

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