A business can be legally structured in several different ways. This article highlights general information, pros, and cons as well as tax implications of various business structures.
This is the simplest and most common business structure as it is the easiest to form and gives the owner complete managerial control over the business. It is an unincorporated business, there is no formal procedure required in its formation and there is essentially no difference between the owner and the business. This means the owner is entitled to all profits as well as responsible for all the business’ losses, debts, and liabilities. As long as an individual is the owner of a sole proprietorship, the status of being a ‘sole trader/proprietor’ comes automatically. Hairdressers, freelance writers, auto repair shop owners and even business moguls like Donald Trump are examples of sole traders. Regulations for sole traders vary by industry, locality and state. You cannot operate your business under an existing name; it must be completely original and you are required to file your name (if different from your own) with the respective authorities.
A sole proprietorship does not distinguish between the owner and the business; they are treated as a single entity. The business is therefore taxed only once, as the owner’s income. However, there is a downside to the tax aspect of being a sole trader; superannuation. This means that only contributions as a self-employed person can be claimed by the owner for tax deductions.
- Very simple and comparatively inexpensive to create and operate
- Profits and losses are reported on owner’s personal tax return
- Fewest legal formalities involved
- Difficulty in raising capital
- Complete control entails heavy burden for the owner
- The owner is personally liable for repayment of business debts or any losses incurred
A general partnership is similar to a sole proprietorship, but with multiple owners (2 to 20 in most cases). There are different kinds of partnerships; limited partnerships, joint ventures and limited liability partnerships, each with their own set of pros and cons. A partnership enjoys the same tax benefits a sole trader does since as the owners and the business are treated as a single entity.
Advantages (in addition to those mentioned under sole proprietorship):
- Low administrative setup and maintenance costs
- Fewer regulatory requirements as opposed to other business structures
- The owners (partners) are personally liable for the actions of the company
- Disagreements and conflicts of interest between partners can hinder the effectiveness of operations
Limited Liability Corporations
An LLC is an extremely popular form of business organization; it is a flexible enterprise that blends the elements of sole proprietorships/partnerships and corporate structure. Owners of an LLC are called ‘members’ and can range from a single owner to any number of members; including individuals, corporations, other LLCs and even foreign entities.
LLCs’ incomes are taxed twice, once at the corporate entity level and the second upon a distribution of share dividends to the shareholders. However, LLCs provide protection and tax savings as the income from the LLC is taxed at individual tax rates.
- Owners, even those participating in management, have a limited liability in the business
- Ownership interest does not determine profit/loss allocation; profits/losses are shared as owners see fit
- Certain regulatory authorities allow LLCs the choice to be taxed as a partnership or a corporation
- There are fewer compliance issues as there is no requirement for a board of directors and also because there is much less paperwork and recordkeeping required as compared to a corporation.
- Much greater capital requirement as opposed to sole proprietorships and partnerships
- Higher regulatory requirements as opposed to other forms of business structure
- The life of the business entity is usually limited to 30 years
- Lack of uniformity in state laws makes it difficult to operate in multiple states
An S corporation (also known as an S-Corp) is a special type of corporate legal form that is taxed similarly to sole proprietorships. Certain legal criteria must be met for its formation, such as the maximum number of shareholders (70).
- There is limited personal liability for owners where business debts are concerned
- There is an allowance for deducting fringe benefits as business expenses
- The owners can use corporate losses to reduce income from other sources
- Numerous legal formalities involved, making the formation a rather complex process
- A lot of paperwork involved as compared to a limited liability company which offers similar advantages
- Income is allocated to owners on the basis of ownership interests
A C corporation (or C Corp) on the other hand is a traditional corporation which can have unlimited shareholders, foreign or domestic, and is taxed separately from its owners. Most major companies opt for this legal structure in order to limit their owners’ legal and financial liabilities.
- Can easily raise finance from venture capitalists as there is a lot of flexibility in making ownership arrangements
- A lower tax cost for accumulating earnings for future expansion
- No restrictions on the ability to have trusts or foreigners as shareholders
- A C Corp can issue multiple classes of stock; common and preferred shares
- High incorporation and maintenance fees
- Double taxation and corporate income tax
- A lot of paperwork and formal board meetings required in addition to the need to file several tax forms with local, state and federal authorities
Tax implications for ‘S’ and ‘C’ Corporations:
Since S corporations treat the business and the owner as a single entity, S corporations themselves are not subject to income tax; their shareholders are liable to tax on income from their shareholdings. However, C corporations are legally considered separate entities from their owners and their income is therefore taxed twice; once at the corporate level and again upon distribution to the owners (shareholders).