For tax purposes, the IRS recognizes 5 major types of business structures; 1) Sole Proprietorships, 2) Partnerships, 3) Corporations (also known as C Corporations), 4) S Corporations, and 5) Limited Liability Company (or LLC). Each of these types of business entities varies by country so be sure to check with your country’s tax collecting authority to determine your options. If you are not much of a do-it-yourselfer and want confidence that your papers will be filed properly, the folks at legal zoom can help you get started.
Think of Sole Proprietorships as the bare bones type of businesses (in terms of legalities). In most states, when filing your paperwork with the state, you don’t need to pay any fees to operate as a Sole Proprietorship. The business and Proprietor are considered one. The only requirement is that you record any income that you earn on your individual tax return.
This type of business entity has one of the largest drawbacks of all the options you have available to you. Because you and the business are considered one, you are personally liable for any and all liabilities that the business faces. This includes the unfortunate event that a lawsuit is brought against your business. If the party that brought the lawsuit against your business wins, you are personally liable to pay for all debts.
Unlike the Sole Proprietorships that are formed by one person, Partnerships are formed by two or more people. These parties will all share in the management and profits of the business. There are only two types of partnerships; General and Limited.
In a General Partnership, the partners manage and assume responsibility as outlined in the partnership agreement. Limited Partnerships are made up of both general partners and limited partners. Like in the General partnership, the general partners manage the business. The limited partners act as investors and don’t assume any responsibility for the day-to-day operations of the business. A major benefit to Partnerships is the “pass-through” of the income tax liability or benefit to the individual partners.
When we see the word “Corporation” we tend to think about multi-national conglomerates that are household names. However, many businesses file as Corporations or “C Corps” for the legal and tax benefits. Corporations are recognized as individual, separate entities that are given the right to operate in the state where the articles of incorporation are filed. When filing, there is generally a fee that must be paid to the state followed by a recurring, annual fee to maintain your records.
After receiving your verification papers back from the state, 2 things must occur. The first, the distribution of stock by the company to the founders/shareholders in exchange for cash or other assets to fund the business. The second, the appointment of the board of directors. The board of directors will elect the president, vice-president, treasurer, etc. of the company. In the event you are the only one starting a C Corp, you can do and be all of these things. Depending on your state, you might be required to fill out the above information on your incorporation documents.
If Corporations are properly formed, they protect the shareholders from liability in the event that a lawsuit is brought against the company. In the event that the Corporation loses a lawsuit, the most that a shareholder can lose is the number of shares that they hold. Another benefit to Corporations is their tax benefits. Corporations file and pay for their own taxes.
Sub-Chapter S (or S Corporations) are a very attractive option for small business owners. It provides the “best of both worlds” where the tax benefits are more favorable than the standard Corporation and the S Corporation filing provides the same protections as the standard Corporations.
In order to become an S Corporation, you must first file with your state as a Corporation. Once you are approved in your state, you must file a request with the IRS to become a Sub-Chapter S entity by filing form 2553 with the IRS (Sub-Chapter means a subsection of the corporate tax code). There are a few tricks with becoming an S Corp. First, you must elect to become an S Corp within 2 months and 15 days after the first day of the taxable year. Also, some states disregard subchapter S entirely whereas some will recognize it automatically.
One of the major drawbacks to an S Corp vs a C Corp is that an S Corp is only allowed to have up to 75 shareholders.
Limited Liability Company
A Limited Liability Company or LLC offers the liability protection the Corporations offer but don’t carry all of the requirements of Corporations including issuing shares, appointing the Board of Directors, or having annual shareholder meetings. Unlike with Corporations, the owners of an LLC are called members, not shareholders.
The Managing Members’ share of profit in the LLC is considered income and is subject to self-employment tax.