So you decide to start your own business. One of the first questions you should ask yourself is: What form of business organization should I adopt to operate my business?
You may adopt one of the six major forms: (1) sole proprietorship, (2) general partnership, (4) limited partnership, (5) limited liability company, and (6) business corporation. Deciding on the right form of business organization often involves questions of personal liability, taxation, control and the raising of capital, among many other issues to be considered. Each form of business organization has advantages and disadvantages that make it a prudent choice in some instances but not in others. The assistance of a business lawyer is essential in evaluating all of the factors upon which the choice of business organization is based.
Sole Proprietorship: This is the simplest form of doing business. A sole proprietorship is not a legal entity. It has no life of its own apart from the owner of the business. It is easy to set up: all you have to do is start your business.
Liability: This is the major disadvantage of adopting sole proprietorship. A sole proprietor is personally liable for the business' obligations. If your business fails and the business does not have sufficient assets to meet its obligations to its creditors (taxes, inventory, cash, contracts, etc.), your personal assets may be used to satisfy those obligations.
Taxation: The major advantage of sole proprietorship is its taxation. A sole proprietor is the business owner himself and therefore all profits and losses of the business belong to the business owner and become part of his or her income tax return.
Control: You have absolute control because you are the owner of your business.
Filing requirements: You do not need to file anything before you start your business. However, if you intend to use a business name (e.g., Art World or XYZ Computer Consultancy), you are required to file a Business Certificate with the Clerk of the County where your principal place of business is located. Also, depending on the nature of your business, you may be subject to various city license and permit requirements.
General Partnership: If you do business together with one or more other persons, you may adopt a general partnership. A general partnership has many of the same advantages and disadvantages of a sole proprietorship.
Liability: each partner in a general partnership is jointly and individually liable for the obligations of the partnership.
Taxation: a partner's share of the partnership's profits or losses belongs to himself and is included in his individual tax returns.
Control: Unless specified in the partnership agreement, each partner shares equal control of the business and equal rights as to profits of the business.
Partnership Agreement: A partnership agreement may be used to specify the relative rights to management and profits of each partner, the requirements of admitting new partners, and the duration of the partnership, etc.
Filing Requirements: Same as a proprietorship, you do not need to file anything before you start your business. However, if you intend to do business under an assumed name (e.g., Buddy Computer Consultancy), you are required to file a Certificate of Partners with the Clerk of the County where your principal place of business is located. Also, depending on the nature of your business, you may be subject to various city license and permit requirements.
Limited Partnership: A limited partnership consists of two kinds of partners - general partners and limited partners. It is a statutorily created form of business organization and must conform with certain filing requirements before it can start doing its business.
Liability: General partners have the same rights, powers and liability as partners in an ordinary general partnership. Limited partners are those whose liabilities are limited to their investment in the business.
Taxation: A general partner may treat his share of profits or losses of the business as his own income or losses. However, a limited partner must treat his share of profits or losses as investment income or losses (the deductibility of investment losses is subject to certain restrictions and you should consult your accountants for further explanation).
Control: Limited partnerships are generally controlled and managed by general partners. As a general rule, limited partners do not participate in managing the business.
Filing Requirements: A limited partnership must file a certificate of limited partnership with the Secretary of State before beginning to do business.
Limited Liability Company: A limited liability company, or LLC, is another statutory entity. It is neither a partnership nor a corporation, but a "hybrid" entity. It is formed by filing articles of organization with the Secretary of State. Most of the provisions regulating the internal affairs of the LLC are contained in an operating agreement that is entered into by the owners. An operating agreement is similar to a partnership agreement. The owners of an LLC are called members.
Liability: The members of an LLC are generally not personally liable for the company's debts. Their status of liability is similar to that of a shareholder in a corporation and a limited partner in a limited partnership.
Taxation: A limited liability company may elect to be taxed as a partnership, and therefore enjoys the advantage of flow-through taxation.
Control: The members may manage the business themselves. They may also elect to have the company managed by one or more managers. In either case, they will not lose their status of limited liability.
Filing Requirements: A limited liability company must file articles of organization and conform with certain state requirements before it can start its business.
Business Corporation: This is the most complex form of business organization. Both its formation and its internal operations are governed by state law. It is an independent legal entity and has its own life. Its life is perpetual unless it is dissolved by its owners (voluntary dissolution) or the state (judicial dissolution). A corporation is the most flexible form of business organization and the best form to obtain loans and other financing.
Liability: The greatest advantage of a corporation is that its owners, called shareholders, are generally insulated from liability of the corporation. If the corporation owes its creditors (including its landlord, suppliers, contractors, and tort creditors) certain obligations (whether they are monetary or not) that it is unable to satisfy, it is generally the corporation's problem and not yours. The shareholders' personal assets are protected from the corporation's liabilities as long as the corporation is run properly.
Taxation: A corporation is generally taxed as an independent entity unless its owners elects it to be taxed as a Subchapter S corporation. In other words, it is subject to "double taxation" - that is, the corporation pays a tax on its income when earned, and its shareholders pay a tax on the income when it is distributed to them in the form of dividends.
Subchapter S Election: Becoming an S Corporation eliminates your income from being taxed twice - once on your business' profits and once more on the salary your business pays you. Instead of paying income taxes directly to the IRS or state, an S corporation passes its profits or losses to the shareholder, who is usually taxed at a lower rate. There are certain restrictions on a corporation's eligibility of becoming an S Corporation. The most important are that an S corporation must have fewer than 75 shareholders and no shareholder can be a nonresident alien.
Control: A corporation is managed by its Board of Directors, who are elected by the shareholders of the corporation. Shareholders can elect themselves to the Board of Directors so that they can operate the business directly. They may also elect other people who are not shareholders to the Board of Directors. The degree of control depends on one's percentage of ownership absent any shareholders' agreement.
Shareholders' Agreement: If your corporation has several shareholders, you may need a Shareholders' Agreement to specify your relative rights as to election of Board Members and officers, control of management, restrictions on transfer of ownership, and admission of new shareholders, etc.
Filing Requirements: Generally, a corporation must file its Certificate of Incorporation with the Secretary of State before it can operate its business as a corporation. There are other filing requirements such as annual filing of officers' list, periodic filings of corporate tax returns, etc. If a corporation wishes to do business in another state, it must file a Certificate of Qualification to Do Business in that state.