There are several ways to organize a business, and the option selected depends on various factors. A small, family‑owned and operated business will likely choose a different structure than a larger company with several owners and many employees.
Each option has benefits and drawbacks. The option selected by a business may change over time as the business’s needs, identity, size, budget, and liabilities change. A person may start out as a sole proprietor but decide to incorporate years later after growing their business and hiring a staff.
But with so many business types out there, how do you choose? Should you set yourself up as a sole proprietor? Should you incorporate, and, if so, do you do so as an LLC, an s-corp or a c-corp?
We’ll try to sort through some of the confusion with these next few posts. First, we’ll look at Sole Proprietorships and Partnerships. These have a few commonalities, including the important fact that debts and liabilities are tied to the individuals (either the sole proprietor or the partners).
Another commonality is that to operate as a business, you will need to secure a Federal Tax Identification Number and you will also need to register your business name. Depending on your state, the business name registration may be known as a DBA (Doing Business As), Fictitious Business Name or FBN, Assumed Business Name or ABN or a Trade Name.
Sole Proprietorship
A sole proprietorship is the simplest form of business organization. One person owns, manages, and controls the business. A sole proprietorship may have employees, but only the owner is in charge of the business. The owner receives the business profits and losses. This person is also responsible for any debts the business may incur. Income, expenses, and losses are reported on the business owner’s individual tax return.
A sole proprietorship is relatively easy to organize. The business owner must acquire the appropriate licenses, if any, a tax identification number and must register the business name.
The benefits of the sole proprietorship include having complete control over the business, ease of the initial set‑up and having business profits taxed at the individual taxpayer rate, which is lower than the rate charged to corporations.
The drawbacks to sole proprietorship include being personally liable for debts and liabilities of the business. For example, if a business owner has debts that are not being paid, the creditors can reach the personal assets of the business owner, such as a personal checking account. A business owner may obtain insurance to minimize this drawback. Other drawbacks include lack of continuity—when the business owner dies, the business ceases to exist—and generally not being able to deduct benefits like health, dental, and life insurance on a sole proprietor’s income tax return as business expenses.
A sole proprietor business is a great choice for independent consultants with fixed costs or small side businesses. If you don’t foresee your business having much financial liability tied up in things such as inventory and leases, consider a sole proprietorship.
Partnership
A partnership is a business owned by two or more parties. There are two types of partnership: general and limited.
General Partnership
A general partnership occurs when two or more persons own, manage, and control a business. Persons in a general partnership share the rights, duties, and responsibilities. Partnerships may also have employees; however, only the partners have control of the business activities.
A partnership has more issues to address than the sole proprietorship. Besides obtaining the appropriate licenses and registering the business name, partners must agree on the treatment of business profits, expenses, losses, and other business concerns. Typically, there is a written agreement between the partners to address these issues. Individual states have statutes that specifically govern partnerships.
The benefits of a general partnership include the owners’ control of a business. However, unlike the sole proprietor who has exclusive control, partners share control and responsibilities. Partners have the advantage of having more than one resource for finances, ideas, and sharing the work load. The formation of a general partnership can be less complicated than other business formats, such as limited partnerships and corporations. Finally, profits from the partnership are included on the partners’ individual tax returns and taxed at the individual taxpayer rate, which is lower than the rate charged to corporations.
The drawbacks to a general partnership include being personally responsible for the debts and liabilities of the partnership just like a sole proprietorship. A partner can be liable for debts incurred by other partners in furtherance of the business. A partnership may obtain insurance to minimize this drawback. Business partners are treated like sole proprietors with regard to deducting benefits provided to themselves. Benefits like health, dental, and life insurance may generally not be deducted on partners’ income tax returns as business expenses.
In a general partnership, a business can continue after the departure or death of a partner. State laws govern how to deal with the death of one of the partners. In general, a partnership agreement may detail how a partnership interest may be sold, transferred, or handled upon the death of a partner. Addressing potential issues in an agreement may be one way to prevent disputes from occurring.
Limited Partnership
A limited partnership is similar in many respects to a general partnership. However, in a limited partnership, there are two types of partners—general and limited. Some states require that a limited partnership have at least one general partner and one limited partner. The principal difference between a general and limited partner is that the limited partner can limit his personal liability for partnership debts to the amount he invests in the partnership. The limited partner, in exchange for the reduction in liability, does not control or manage the business. The general partner controls and manages the business and is personally liable for partnership debts.
Because limited partnerships must meet specific statutory requirements, they can be more complicated to establish and often require regular public filings. A limited partnership must also receive appropriate licenses, tax identification number and register the business name.
The benefits of a limited partnership depend on whether one is a general or limited partner. The general partner enjoys control and management responsibilities. The limited partner receives limited personal liability. Profits for both types of partners are included on the partners’ individual tax returns and taxed at the individual taxpayer rate, which is lower than the rate charged to corporations.
The drawbacks for a limited partnership also depend on whether one is a general or limited partner. A general partner is personally responsible for the business debts while the limited partner is only liable for debts up to the amount invested in the partnership. The limited partner does not participate in the management or the control of the business. Business partners are treated like sole proprietors with regard to deducting benefits provided to themselves. Benefits like health, dental, and life insurance may generally not be deducted on partners’ income tax returns as business expenses.
Unlike a sole proprietorship or general partnership, when a limited partnership wishes to dissolve, it typically must file such intent with the state Secretary of State. As mentioned previously, there are laws which apply to limited partnerships specifically which make this format more time consuming and complex.
We’ve gone over some of the simpler forms of business organization. Next, we’ll tackle different types of corporations, including S-Corps, C-Corps and LLCs.