Congratulations! You\’ve decided to finally pull the trigger and launch your own business. One of the first – and most important – decisions you need to make is: What type of business structure to establish. The most common types of business structures are sole proprietorship, partnership, corporation, S corporation and limited liability company (LLC). Each form of entity has its own pros and cons. When selecting a business structure, it\’s important to weigh the legal and tax options of each one, and which best fits your business. Common questions we ask our clients when advising them are: how will the business raise capital? How many owners will there be and what is the relationship between the owners? What is your business plan (short, intermediate, and long term)? Many new entrepreneurs decide they can \”do it themselves\” and incorporate using an on-line do-it-yourself service in order to save initial costs – however, not doing it right the first time often ends up costing them much more in the long run.
The truth is that good business counsel at the start-up phase does not have to be expensive, and the good advice and services we provide add value, not cost, to your start-up venture. Here\’s a simple overview of the most common business structures and the advantages and disadvantages of each:
A sole proprietorship is owned by one person and there is no legal distinction between the owner and the business. All profits and losses are accrued to the owner, and subject to taxation as ordinary income of the owner. The advantages of a sole proprietorship is that they are easy to start up and easy to discontinue because the business owner has full control over the business. It is also the simplest to administer tax-wise because the owner takes all profits from the business, and only pays taxes on profits and is not subject to corporate taxes. The profit or loss is reported on Schedule C of the owner\’s individual federal income tax return. The number one disadvantage of a sole proprietorship is that the owner is not protected from liability for the debts and obligations of the business. Also, it can be harder to raise capital.
In a partnership, owners share the profits and losses associated with the business. The advantages are that you don\’t have to register with the state or pay fees to start a partnership, and filing taxes is easy since – like a sole proprietorship – only the partners are taxed, not the business. The disadvantages are that all partners are personally responsible for any business debts or liabilities. Plus, if you don\’t completely trust your partner, a falling-out could wreck your start-up success. That is why it is critically important that a partnership agreement be agreed upon and signed by all the partners. The partnership agreement is a document that states how the business will be run, how profits (or losses) will be divided, and what happens if one partner dies or the partners cannot agree, etc.
Corporations are the most common form of business organization. A corporation is recognized as a separate legal \”person\” with legal rights separate from its owner(s), thus keeping its owner(s) from being liable if the company is sued. Corporations are owned by a one or more people known as shareholders. The advantages of a corporation are its limited liability that protects its owners from legal trouble or the business\’ debts. The corporation pays separate taxes from its owners, so the owners only pay taxes on corporate profits paid to them through salaries, bonuses and dividends. On the other hand, the disadvantages are more paperwork associated with making your business a corporation, as well as state filing fees. Also, unless it is an S Corporation, your corporation will have to pay its own taxes.
An S Corporation is a corporation that meets certain criteria so that the corporation\’s income passes through to its owners/shareholders and is not taxed at the corporate level. Limited personal liability of owners is one of the advantages, as is not having to pay corporate income taxes. The disadvantages are the same as a corporation, namely costs to set up and compliance with regulations and requirements to obtain and maintain \”S\” status. Like a partnership, a corporation or S corporation should have a Shareholders\’ Agreement. Like a partnership agreement, the Shareholders\’ Agreement spells out the rights and obligations of the shareholders.
A Limited Liability Company (LLC) is a hybrid of a sole proprietorship/partnership and a corporation. LLC owners (called \”members\”) have limited personal liability, like a corporation, but they can elect to have the LLC treated as a corporation or sole proprietorship/partnership for tax purposes. This is the LLC\’s greatest advantage: a flexible tax structure, allowing members to decide if they want to be taxed as a corporation, sole proprietor, partnership or S corporation. Also, the owners of an LLC are protected from the acts or debts of the company. There are not many disadvantages to forming an LLC. Raising capital may be one, and it may require that the members personally guaranty the debt. Cost is another potential disadvantage. In New York, there is a legal requirement that a notice of formation be published in designated newspapers when the LLC is created. This requirement of publication increases the costs of forming an LLC significantly. An LLC should have an Operating Agreement which is the equivalent of a Partnership Agreement and/or Shareholders\’ Agreement.
We have been advising entrepreneurs of all sizes in New York and New Jersey since 1992. Our motto is \”CREATE + GROW + PROTECT\”. Get your business off on the right track with sound legal advice and good counsel. Call us today.