Before you start a business, you need to decide what kind of structure your business will follow. The type of businesses organization you choose will determine the amount of taxes levied on it and the nature of legal issues it may face. The most common type of business organizations include sole proprietorship, partnership, corporation, S corporation and limited liability company (LLC). Each type of business organization has its own advantages and disadvantages, so it is best to get some advice from a lawyer and an accountant to determine which business organization suits your business goals.
Most people who start a small business on their own, choose the sole proprietorship model because it’s the simplest type of business organization, in terms of legal issues and taxation. There is only one owner in a sole proprietorship. All the business assets and profits belong to the sole proprietor. However, there is limited financial safety, because the owner is personally responsible for all financial liabilities. The income and expenses related to the business are filed under the owner’s personal tax return.
When two or more people own a business together, it is called a partnership. The partners sign an agreement that defines their responsibilities, contributions, profit share and the terms of dissolution of partnership. The partners are equally responsible for any debts that the business might incur. Partnerships need to file annual tax returns but do not pay income tax. The partners share the profits and report them in their personal tax return.
A corporation is a unique legal entity that is separate from its owners. The owners of a corporation may change, but the corporation remains as a unique entity. The owners (shareholders) of a corporation choose a board of directors that is responsible for making business decisions, paying taxes and dealing with legal issues. The formation of a corporation can be a time- and money-consuming process due to all the paperwork and legalese involved. A big disadvantage is that a corporation may be taxed twice: once on income generated and once on dividends paid to shareholders.
S Corporations differ from corporations in that they are only taxed once. The shareholders are taxed (at the individual income tax rate) on dividends paid by the corporation. A business can only register as an S corporation if it is based domestically, has at most 100 shareholders and has one category of stock. Insurance companies, particular financial institutions and companies with international sales are not eligible to register as an S corporation.
Some states allow the formation of LLCs, which combine the tax benefits of a partnership and financial liability benefits of a corporation. The owners (members) of an LLC can include individuals and other business organizations. Financial institutions and insurance companies are not allowed to operate as LLCs.