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Understanding the Business Structure
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A major federal requirement for all new enterprises is the declaration of a company’s business structure. For income tax purposes, a new business needs to decide which type of organization will give their company the best liability and tax break. There are four common forms of business entities that a new entrepreneur may consider. They include sole proprietorship, partnership, corporation, and Limited Liability Company. The following tables explain the four common business structures with their unique characteristics and requirements. The entrepreneur needs to evaluate all of these possible choices, and then decide which entity best suits their new business.

Sole Proprietorship


Definition

As a sole proprietor, the business owner plans to work and operate his/her business alone with no other hired staff.

Advantages

• Simple structure, easy to start, less paperwork involved, very little or no legal help is needed.
•No complicated income tax forms to fill out; business earnings are taxed only once.
• Candidates who are required to pay estimated tax payments can pay the amount four times a year.
• You are your own boss and can start your business at any time.
• There are low startup costs, and the sole proprietor can pocket all the profits that are made.
• Can save $1,000 to $2,000 per year if the sole proprietor employs their minor children (18 years or younger).
• Can easily upgrade corporate structure to partnership, corporation, or LLC in near future.

Disadvantages

• Limited financial opportunities thus raising capital from investors and lending institutions may be difficult; therefore, the sole proprietor must rely on bootstrap money and family to finance their business.
• Can be held personally liable for all debts and obligations of the business.
• The sole proprietor is held responsible for all business decisions made.

Liability Requirements

• Sole proprietors are personally responsible for their company’s liabilities (personal liability), putting all of their assets at risk.
• Unlimited legal liability

Capital Requirements

• Depends how much the entrepreneur is willing to put in.
• Money for the business is usually from personal finances and from family and friends.

Corporate size

One person company.

Duration of the company

Unlimited duration and usually discontinues if owner retires, becomes disabled, or passes away.

Transfer of ownership

• Can sell his/her company as s/he sees fit.
• Company assets (personal assets) usually sold as a whole or in portions.

Federal tax forms

• Form 1040: Individual Income Tax Return 
• Schedule SE: Self-Employment Tax
• Form 1040-ES: Estimated Tax for Individuals
• Form 941: Employer’s Quarterly Federal Tax Return
• Form 940: Employer’s Annual Federal Unemployment Tax Return.

General Partnership (GP)


Definition

In a general partnership, each partner assumes their duties and responsibilities equally.

Advantages

• Have similar roles to a sole proprietor and often referred to as a “multi-person sole proprietorship.”
• Not required to register with the state or pay high fees (as corporations and LLC’s do).
• Is organized as a “pass through” legal structure whereby each general partner is taxed, not the whole partnership (unless the partnership requests to be taxed like a corporation).
• Easy to start, ideal for short-term situations.
• Capital is easier to raise in a general partnership compared to sole proprietorship.
• Involves very little legal requirements.
• Profits and losses are divided among partners.

Disadvantages

• There is no liability protection for each partner. All partners of a general partnership are held liable for business debts that have accrued and any other liabilities.
• Unequal amounts of work among members of a general partnership can result in conflicts and relationship strains.
• Not a good structure to choose if the partnership wants large amounts of capital.
• Can be more expensive than sole proprietorship because partnerships require more legal and accounting services.
• All partners are bound to the same action/decision of one partner.

Liability Requirement

Regardless of which partner acquired the liability, all partners in a general partnership will be held liable.

Capital Requirements

Done in accordance with the partnership agreement.

Corporate size

Two or more persons.

Duration of the company

Lasts according to the partnership agreement.

Transfer of ownership

Based upon the partnership agreement.

Federal tax forms

• Form 1065: Partnership Return of Income
• Form 1065 K-1: Partner's Share of Income, Credit, Deductions
• Form 4562: Depreciation
• Form 1040: Individual Income Tax Return
• Schedule E: Supplemental Income and Loss
• Schedule SE: Self-Employment Tax
• Form 1040-ES: Estimated Tax for Individuals

Limited Partnership (LP)


Definition

In a limited partnership, there are one or more general partners and one or more limited partners involved. General partners assume equal duties and responsibilities in managing and operating the business while the limited partners have a more passive role.

Advantages

• Income is taxed as personal income only.
• Capital is easier to raise in a partnership compared to sole proprietorship.
• Ideal structure for partners who do not want an active role in operating a company.
• Minimum government regulations.
• Limited partners not held responsible for the debt and liabilities of the company.
• General partners have complete control over the company.
• A good structure for general partners who want to acquire more money but do not want the added management control.

Disadvantages

 

•Involves much more startup requirements, regulations, complex paper work.
• More expensive to create than a general partnership.
• General partners of a limited partnership have no liability protection.
• Can decide to remove their invested funds from the company at any time, if necessary.
• Since they have a “silent” role in daily operations of a business, they may not agree with how general partners are managing the company.

Liability Requirements

• Limited partners have liability protection.
• General partners are not protected from liability.

Capital Requirements

Based according to partnership agreement.

Corporate size

Two or more persons.

Duration of the company

Ends when one partner terminates the partnership by leaving the company or from passing away.

Transfer of ownership

Based upon the partnership agreement.

Federal tax forms

• Form 1065: Partnership Return of Income
• Form 1065 K-1: Partner's Share of Income, Credit, Deductions
• Form 4562: Depreciation
• Form 1040: Individual Income Tax Return
• Schedule E: Supplemental Income and Loss
• Schedule SE: Self-Employment Tax
• Form 1040-ES: Estimated Tax for Individuals

Corporation (C-Corp or C-Corporation)


Definition

A C-corporation is a legal, for-profit, independent organization that is supported by the state in which it is based. Shareholders are the owners of the corporation.

Advantages

• Offers unlimited legal and asset liability protection for owners (shareholders).
• Shareholders are offered different classes of stock and have voting rights.
• Organization consists of a hierarchy structure of management whereby all titles and duties are defined.
• Easy to raise capital with this type of organizational entity.

Disadvantages

 

• Corporation must abide to complex rules, regulations, forms, fees, and stock certificates.
• Double taxation, both corporation and stockholder income is taxed.
• Must hold director and shareholder meetings and record corporate minutes.
• Expensive to form.

Liability Requirements

Limited liability protection

Capital Requirements

Easy to raise money as a corporation as compared to the other structures but is an expensive process to start a corporation.

Corporate size

One or more people.

Duration of the company

Unlimited so does not dissolve when ownership changes.

Transfer of ownership

Can occur at anytime.

Federal tax forms

• Form 1120: U.S. Corporation Income Tax Return or
• Form 1120A: U.S. Corporation Short-Form Income Tax Return

Subchapter S-Corporation (S-Corp or S-Corporation)


Definition

An S-corporation is a legal, for-profit, organization that was created to meet the needs of the owners by relieving them from harsh corporate taxes but providing them with the liability protection that a corporation has. It is supported by the state in which it is based. Shareholders are the owners of the corporation.

Advantages

• Stockholders have liability protection.
• Is a “flow through” entity, whereby each shareholder is individually taxed, not the corporation as a whole; however, each shareholder must report the income or loss generated by the S-corporation in their individual tax return.
• Shareholders can use the “cash method” of accounting, where income is taxable when received and expenses are deductible when paid.
• Has the ability to raise more capital since the S-Corporation structure may have up to 100 shareholders.

Disadvantages

 

High legal and accounting costs.
• Can only issue one class of stock.
• Subject to an abundance of state regulations and yearly requirements.
• The Board of Directors represents the stockholders.
• Expensive startup costs.
• Complex startup requirements as entity must first file for C-Corporation structure followed by S-Corporation status; can only form once every 5 years.

Liability Requirements

Liability protection to stockholders.

Capital Requirements

• More shareholders attract more investors; therefore it may be easier to raise money.
• Ability to raise capital may be limited due to the fact that only one class of stock is offered to stockholders.

Corporate size

One or more people.

Duration of the company

Unlimited so does not resolve when ownership changes.

Transfer of ownership

Can occur at anytime.

Federal tax forms

• If the S-corporation owes income tax, it must be reported on Form 1120S: U.S. Income Tax Return for an S-Corporation.
• Shareholders will report income using Form 1040, Schedule E: Supplemental Income and Loss.
• Self employment tax is reported on Form 1040, Schedule SE:  Self Employment Tax.

Limited Liability Company (LLC)


Definition

An LLC is a modern business entity that is organized in such a way that it combines several features of corporations and limited partnership characteristics. It has the liability protection and stockholder rights of a corporation with the tax privileges of partnerships. Owners of an LLC are referred to as members.

Advantages

• More attractive characteristics than S-corporations as an unlimited amount of shareholders and each owner has full participatory role in the daily operations of a business.
• The members benefit from pass-through taxation and income is only taxed once.
• More than one class of stock is offered to shareholders.
• Flexible structure allows owners to write off business losses and to take assets out of the company without additional liability.
• Management flexibility.
• Growing in popularity.

Disadvantages

May have limited life of company, depending on state.
• Not suitable for businesses that plan to go “public.”
• May not be well understood by many.

Liability Requirements

Stockholders have unlimited liability protection just as corporations; members cannot be held personally liable for debts unless they have signed a personal guarantee.

Capital Requirements

Since LLC’s may not be easily understood by many, it may hinder angel investors and venture capitalists from investing in them.

Corporate size

Unlimited amount of owners and shareholders.

Duration of the company

Can be virtually unlimited in lifespan; however, depending on the state of operation, the life of an LLC can be restricted. Under state law, some LLC’s may have to dissolve after 30 or 40 years, when a member retires, becomes disabled, dies, or if the company declares bankruptcy.  

Transfer of ownership

• Requires the consent of other members.
• Owner can sell or transfer the ownership to whomever they wish.

Federal tax forms

• If there is one owner, the LLC will be taxed as a sole proprietor.
• Form 1040: Individual Income Tax Return 
• Form 1065: Partnership Return of Income
• Form 1065, K-1: Partner's Share of Income, Credit, Deductions

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