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What Classification of Business is Right for You?

When starting a business, consider legal structure

One of the most important decisions you will make when starting a business is the type of legal structure under which you select to operate. This decision will depend on the type of business you intend to run, the number of owners it will have, and its financial situation. The potential risks and liabilities of your business, the formalities and expenses involved in establishing and maintaining the business, tax consequences, and investment needs should also be considered. There is no universal answer that applies to every business. Below are the four most common business formation structures and their general principles to consider when choosing a structure that best suits your business’s needs.

5 Common Business Classifications

Sole Proprietorship: The simplest structure chosen when starting a business is the sole proprietorship. This type of business entity is owned and operated by one person, and there is no legal distinction between the owner and the business. Accordingly, you are entitled to all profits. However, as a sole proprietorship you are also personally responsible for all of your business’s debts, losses and liabilities – placing your assets at risk. Under this structure the business itself is not taxed separately because the business’s income is your income. The tax aspects are appealing because the businesses expenses are included on your personal income tax return. You do not have to take any formal action to form a sole proprietorship.

Partnership: A partnership is a single business where two or more people share in ownership is simple to create and operate. In a partnership, each partner shares in the management of the company. Partners are also entitled to share all profits, but they are also each personally liable for the partnership’s obligations and debts. Partnerships include more than one person in the decision-making process, so it is important to discuss the wide variety of issues that might arise in advance and develop a legal partnership agreement. A partnership does not pay tax on its income but “passes through” any profits or losses to the individual partners. The tax benefits enjoyed by partnerships can make this structure an appealing choice. Partnerships come in two varieties: general and limited. To form a partnership you must register your business with your State.

Corporation: A corporation is an independent legal entity owned by shareholders. The greatest benefit of a corporation is the liability protection the business owner receives. A corporation’s debt is not considered that of its owners, and, as a result, you are not putting your personal assets at risk. If you intend to have investors, forming a corporation makes it easier to raise money through the sale of stock. However, corporations are more complex than other business structures because they tend to be subject to numerous rules and regulations, with complicated tax and legal requirements. Unlike sole proprietorships and partnerships, corporations pay income tax on their profits. Therefore, owners of the corporation pay a “double tax” on the business’s earnings. It is more expensive to form a corporation and maintain corporate status. To form a corporation you must file Articles of Incorporation with the Secretary of State, in addition to obtaining a permits and licenses that may be required.

Subchapter S (S Corporation): An S Corporation is a corporation that has elected “S Corporation” tax status. An S Corporation issues stock and is governed as a corporation. However, forming an S Corporation allows you to enjoy the limited liability of a corporate shareholder but pay income taxes as if you were a sole proprietor or partnership. Earnings and losses pass through to the owners and are included on their personal tax returns. The business itself is not taxed. There are a number of requisites that must be met in order to qualify for S corporation status. First and foremost, if a new corporation, then the corporation must elect this status within the first 75 days of formation. The corporation must be a “conventional,” for-profit corporation that has only one class of stock. The shareholders in the corporation must be U.S. Citizens or Permanent Residents in good standing at the time of stock acquisition. There can be no more than 75 shareholders, and the passive income of the corporation must not exceed 25% of its gross revenue. To form a corporation you must file Articles of Incorporation with the Secretary of State, in addition to obtaining a permits and licenses that may be required.

Limited Liability Company (LLC): A Limited Liability Company is a hybrid business structure, offering the limited liability of a corporation and tax efficiencies of a partnership. Owners have limited personal liability for business debts even if they participate in management. Earnings and losses pass through to the owners and are included on their personal tax returns – the business itself is not taxed. The LLC form allows for an unlimited number of shareholders (known as “Members”). Any member of the LLC is allowed a full participatory role in the business’s operations. While the LLC and S corporation possess many similarities, unlike an S corporation, the LLC is not subject to the traditional corporate formalities. For the majority of small businesses, the relative simplicity and operational flexibility of the LLC make it more appealing choice. However, an LLC is also more expensive to form and maintain, versus a sole proprietorship or partnership structure. To form an LLC you must file Articles of Organization with the Secretary of State and create an Operating Agreements, in addition to obtaining any licenses and permits required.

Addressing how to structure your business up front will help you to better focus on your business later. The key is to find the best fit for your organization. With vast experience in business formation, the attorneys at Anselmo Lindberg & Associates can help guide you in choosing a structure that meets your needs, as well as assist in the formation of the legal structure selected.

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