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Picking Your Business Structure

QUICK SUMMARY

Structuring your company will have a significant impact on all sorts of money matters including your taxes, financing (a significant issue according to the The Hartford’s Small Business Success Study), compensation, and insurance. And don’t forget your exposure to lawsuits. Therefore, a business owner’s first consideration is usually: What type of company do I want to create?

There are generally four questions you'll need to answer:

  • What kind of liability protection do I need?
  • How do I want to pay taxes?
  • What are my financing needs and options?
  • And, how much administrative complexity can I deal with?

Of course there are other issues too. But when you’ve addressed these four, you should be fairly close to an answer. Here’s a guide to help you understand the pluses and minuses of each type of structure.

Keep in mind that regulations for starting a company differ from state to state. Click here for a list of links to each state’s agency for registering new businesses.

Sole Proprietorships

A sole proprietorship is the simplest business structure, owned by an individual or a married couple.

advantages

  • Set-up costs are minimal
  • There's no complex documentation to file and no state fees
  • Business income is taxed only once as personal income

disadvantages

  • No liability protection of personal assets
  • Subject to self-employment tax
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General Partnerships

A general partnership is similar to a sole proprietorship, except there are two or more owners of the business (who aren’t a married couple).

advantages

  • Minimal set-up costs with no state fees or documentation
  • Flexible structure that can respond to partners’ situation and needs
  • Business income taxed only once as personal income

disadvantages

  • No liability protection of personal assets
  • Can be complicated—rights and responsibilities of each partner are complex
  • Subject to self-employment tax
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Limited Liability Companies (LLC)

A Limited Liability Company or LLC is a hybrid business entity that shields owners’ personal assets from business liability, but allows the returns they earn to be taxed once, as personal income

advantages

  • Shields owners from personal liability
  • Profits taxed only once on members’ personal tax returns
  • Fewer formal administrative and compliance requirements than a corporation

disadvantages

  • Because of the need for a customized operating agreement, may cost as much as an S corporation to set up
  • Requires separate tax return for the LLC
  • Members may be taxed on profits that aren’t actually distributed
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Limited Partnerships

A limited partnership is a complex business structure with two classes of partners: limited (LP) and general (GP).

advantages

  • For LPs, liability shared between limited and general partners
  • Good structure for an entrepreneur who wants to raise capital but retain operating control
  • Business proceeds taxed as the partners’ personal income

disadvantages

  • GP’s liability unlimited
  • May be difficult to fine tune the balance of power between GPs and LPs
  • In addition to the partnership agreement, many states require the partners to file a Certificate of Limited Partnership
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C Corporations

A C corporation is a legal entity, with a charter granted by the state in which it is headquartered. It can sell shares of stock to raise money, and shareholders become owners with an interest based on the size of their investments.

advantages

  • The corporation, not shareholders, is liable for the company’s obligations
  • Tax-free benefits, such as insurance, travel, and retirement plan deductions
  • Transfer of ownership facilitated by the sale of stock
  • Change of ownership need not affect management
  • Ability to raise capital through the sale of stock and bonds

disadvantages

  • Incorporation requires start-up fees and complex documentation
  • Corporate entities are monitored by various governmental agencies and must comply with a variety of rules
  • Often requires specialized personnel to deal with tax, accounting, and HR issues that demand compliance
  • Profits are taxed twice, both at the corporate and individual level

 

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S Corporations

An S corporation is structured like a traditional C corporation, except that a special classification from the IRS exempts earnings from double taxation.

advantages

  • Allows small businesses to pay taxes only once on the owners’ personal returns
  • The corporation, not shareholders, is liable for the company’s obligations
  • Tax-free benefits, such as insurance, travel, and retirement plan deductions
  • Transfer of ownership facilitated by the sale of stock
  • Change of ownership need not affect management
  • Ability to raise capital through the sale of stock and bonds

disadvantages

  • Limited to 100 shareholders and excludes ownership by foreigners and other corporations
  • Only one class of stock permitted
  • Incorporation requires start-up fees and complex documentation
  • Corporate entities are monitored by various governmental agencies and must comply with a variety of rules
  • Often requires specialized personnel to deal with tax, accounting, and HR issues that demand compliance
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Business Structures for Professional Firms

Professional Corporations (PCs), Professional LLCs, and Limited Liability Partnerships (LLPs) are versions of basic business structures that provide some liability protection for certain types of professional firms, such as medical and legal practices, which may be exposed to enhanced liability risk.

advantages

  • Designed specifically for professional firms
  • One partner is not liable for another partner’s misconduct or negligence
  • Allows choice of best structure—Professional Corporation, Professional LLC, or Limited Liability Partnership—for your company’s taxation preferences and fundraising needs

disadvantages

  • A partner can’t eliminate or limit liability for his or her own negligent, wrongful acts, errors, or omissions
  • Not available in all states
  • States vary significantly as to the limitation of a partner’s liability
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