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Bob and Bill have a business plan. They have their financial backing and they have all their equipment. They should be 100 percent ready to start their contracting business, right? Not necessarily. From a legal perspective, they should also pick the type of business they want. There are several factors to keep in mind when making that decision; anyone starting a business should research the different business types and, for extra guidance, consult an attorney and an accountant.
Five Types
There are five basic types of business entities:
Sole Proprietorships: This is the default mode for a business operated by a single individual. No formal action is required to create a sole proprietorship. The sole proprietorship is not recognized as being separate from its owner; the sole proprietorship is the owner.
Partnerships: A partnership is an association of two or more people as co-owners of a business for profit. No formal action is required to form a general partnership; this is a default entity arising when two or more people go into business together. While not required, a written partnership is highly recommended.
Limited Liability Companies (LLCs): Limited liability companies are an increasingly popular form of business entity. LLCs do not require that at least one member or owner have general liability, and forming one doesn't require formal action. Usually, the organizer(s) must file articles of organization with the appropriate state office, and the members/owners enter into a written operating agreement.
S Corporation: This is a regular corporation that has between one and 100 shareholders and passes net income or losses to shareholders.
C Corporation: In a C corporation, profits are taxed separately from its owners under subchapter C of the Internal Revenue Code.
Management and Control
With respect to management and control, a sole proprietorship offers the most control and the most responsibility. A sole proprietor has total control over the business and is responsible for management. In a partnership, all general partners are responsible for management. Each partner has an equal voice regardless of the amount of money contributed. Decisions are made by majority vote, but major changes require unanimous consent of all partners.
Control of an LLC is determined by its operating agreement. An LLC can be member-managed or manager-managed. If member-managed, members can have a voice in management in proportion to the money they contributed to the business. If the LLC is manager-managed, the members appoint a manager to oversee the operation of the business.
Corporations (both S and C) have the highest formality of management and control. Control of a corporation is centralized in the board of directors. The board oversees the day-to-day operations of the business and elects officers to make day-to-day decisions. Shareholders elect the board; typically shareholders have one vote per share.
End of the Road
These types of businesses also vary regarding what causes their termination. With respect to the sole proprietorship, the business ends with its owner. In the event of the owner's death, bankruptcy, etc., the sole proprietorship ends. However, the owner can still sell the business's name, assets and goodwill.
The rules for partnerships are similar to sole proprietorships. Unless a partnership agreement provides otherwise, a general partnership is dissolved upon the death, bankruptcy or withdrawal of a partner. A partnership may also be dissolved by court order. Most partnership agreements provide for surviving parties to continue the business, but require the survivors to pay the estate of the deceased partner the value of his or her interest. A partner may withdraw at any time and dissolve the partnership—even if this act violates the partnership agreement. If a partner chooses to withdraw, he or she can force the other partners to purchase his or her interest in the business, or else the assets of the partnership are sold when the partnership dissolves. If the withdrawal is against the partnership agreement, the withdrawing partner will have to pay various penalties. The remaining partners have the option to continue the business without the partner who decided to withdraw his interest. The remaining partners also may buy out the withdrawing partner's interest.
Events causing termination of an LLC are controlled by the operating agreement. In the absence of provisions to the contrary in the operating agreement, the LLC dissolves on the death, incapacity, bankruptcy or resignation of a member unless all other members vote to continue within a certain time period after the event. Any member of an LLC may withdraw at any time (even if voluntary withdrawal is prohibited by the operating agreement), and is entitled to receive the fair value of his interest in the LLC. If the withdrawal violates the operating agreement, the other members may sue the withdrawing member for damages. The LLC can also be dissolved by court order.
Corporations have perpetual existence unless their articles of incorporation provide for a shorter term. If they choose, the shareholders can agree in advance that the corporation will be dissolved in specific circumstances such as the death or disability of one of the key participants. Individual shareholders do not have the right to withdraw their share of money from the corporation, but they can sell their stock.
Taxation
With respect to taxation, the sole proprietorship is nonexistent. The owner is taxed on the business's income at his personal tax rates, and he is able to deduct the business's losses and offset them against income from other sources.
Similarly, partnerships are subject to a single level of tax. The companies file a partnership income tax return each year, but the partnership itself pays no tax. Instead, the partners report their proportionate share of partnership income on their own individual tax returns.
LLCs are subject to a single level of tax. When an LLC is owned by a single owner, all income and expenses are reported on the owner's personal income tax return. Multiple-owner LLCs are taxed as a partnership. The LLC files a partnership income tax return each year, but the LLC itself pays no tax. Instead, the owners report their proportionate share of LLC income on their personal tax returns.
S corporations are also subject to a single level of tax and are similar to a partnership for tax purposes. The S corporation files an income tax return each year but pays no tax. Instead, the owners report their proportionate share of S corporation income on their own personal tax returns.
C Corporations are subject to a second level of tax. The corporation files an income tax return and pays taxes on all its income on corporate rates. C corporations do not receive the reduced capital-gain tax rate that applies to the other entities. When the C corporation pays money to its shareholders as a dividend or as a salary, it is subject to tax a second time.
Liability Legwork
With a sole proprietorship, the owner has to pay all the debts of the business, including contracts and responsibility for negligence or other wrongful acts of employees.
Insurance can be used to protect sole proprietors to some extent for negligence claims. However, there is no way to reduce the risk of personal responsibility for the business's contracts.
In a partnership, the general partner has no liability protection. For this reason, when a general partnership structure is used, the general partner is often a corporation (creating another level of complexity). Limited partners in a partnership have liability protection, but the level of protection may not be as great as what would be received if the entity were an LLC or corporation.
Members and managers of an LLC are responsible for the debts of the LLC only to the extent of their initial contributions to the LLC. Members may face additional personal responsibility for corporate debts if they do not act like an LLC—for example, when members take virtually all money out of the LLC for themselves, leaving only minimal assets in the business.
In a corporation, the shareholder's personal responsibility for corporate debts and obligations is limited to the shareholder's original investment in the corporation. There are, however, certain exceptions. For example, shareholders may be personally liable for corporate debts if they do not act like a corporation (for example, where the shareholders did business in their own personal name by not letting others know that they were acting as a corporation).
Based on these factors, one of these business forms will meet your needs. Consult an attorney or accountant for help, and be sure you're always doing the best you can for you and your business.