Starting a business with a partner? It may be difficult to talk about problems during your honeymoon stage, but that's exactly when you should. A written partnership agreement helps guide you when questions arise.
According to W. Thurston Debnam Jr. Debnam recommends that every business partnership-regardless of the relationship of the individuals-begin with a written agreement. But there's another reason for a partnership agreement. Using the corporate structure is more complex and expensive than most other business structures. A corporation is an independent legal entity, separate from its owners, and as such, it requires complying with more regulations and tax requirements.
The biggest benefit for a small-business owner who decides to incorporate is the liability protection he or she receives.
A corporation's debt is not considered that of its owners, so if you organize your business as a corporation, you're not putting your personal assets at risk. A corporation also can retain some of its profits, without the owner paying tax on them.
Another plus is the ability of a corporation to raise money. A corporation can sell stock, either common or preferred, to raise funds. Corporations also continue indefinitely, even if one of the shareholders dies, sells the shares or becomes disabled. The corporate structure, however, comes with a number of downsides. A major one is higher costs. Corporations are formed under the laws of each state with their own set of regulations.
You'll probably need the assistance of an attorney to guide you through the maze. In addition, because a corporation must follow more complex rules and regulations than a partnership or sole proprietorship, it requires more accounting and tax preparation services.
Another drawback: Owners of the corporation pay a double tax on the business's earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.
To avoid double taxation, you could pay the money out as salaries to you and any other corporate shareholders. A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense.
Keep in mind, however, that the IRS has limits on what it believes to be reasonable compensation. How to Incorporate To start the process of incorporating, contact the secretary of state or the state office that is responsible for registering corporations in your state. Ask for instructions, forms and fee schedules on business incorporation.
It's possible to file for incorporation without the help of an attorney by using books and software to guide you along. Your expense will be the cost of these resources, the filing fees, and any other costs associated with incorporating in your state. The disadvantage of going this route is that the process may take you some time to accomplish.
There's also a chance you could miss some small but important detail in your state's law. One of the first steps you must take in the incorporation process is to prepare a certificate or articles of incorporation. Some states will provide you with a printed form for this, which either you or your attorney can complete. The information requested includes the proposed name of the corporation, the purpose of the corporation, the names and addresses of the parties incorporating, and the location of the principal office of the corporation.
The corporation will also need a set of bylaws that describe in greater detail than the articles how the corporation will run, including the responsibilities of the shareholders, directors and officers; when stockholder meetings will be held; and other details important to running the company.
Once your articles of incorporation are accepted, the secretary of state's office will send you a certificate of incorporation. Once you're incorporated, be sure to follow the rules of incorporation.
If you don't, a court can pierce the corporate veil and hold you and the other owners personally liable for the business's debts. It's important to follow all the corporation rules required by state law. You should keep accurate financial records for the corporation, showing a separation between the corporation's income and expenses and that of the owners'. The corporation should also issue stock, file annual reports and hold yearly meetings to elect officers and directors, even if they're the same people as the shareholders.
Be sure to keep minutes of these meetings. On all references to your business, make certain to identify it as a corporation, using Inc. You also want to make sure that whomever you deal with, such as your banker or clients, knows that you're an officer of a corporation.
The S corporation is more attractive to small-business owners than a standard or C corporation. That's because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation.
With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. Additionally, the owner pays all taxes and reports profits and losses on Schedule C of his income tax return — there is no separate corporate entity filing.
While this is certainly the simplest way to run a business from an administrative perspective, there are clear drawbacks, namely, the lack of liability limitation. Since the business owner and the entity are deemed the same, any legal action leveled at the business will attach to the individual as well. Business owners certainly have a compelling interest in separating themselves from their entities to preserve a liability shield. This is where the LLC comes into play.
An LLC is considered a hybrid entity because it has features of both a partnership and a corporation. Like a corporation and unlike a sole proprietorship , LLCs offer personal liability protection for its members. LLCs also provide flexibility when it comes to taxes, as members can choose whether they are taxed as a corporation or as individuals. As with any entity, taxes can get complicated with an LLC, so it is best to consult a small business attorney when forming one and selecting your tax treatment.
A partnership is a slightly rarer entity — the majority of small businesses are run as sole proprietorships or LLCs. A partnership consists of two or more individuals who own and control a business.
It is similar to a sole proprietorship, except that profits, debts, and liabilities are shared among partners instead of borne by the sole proprietor alone. Each partner files his own taxes for their share of the profits and separately report their losses. Multi-owner businesses that want to raise money from investors often do well as LPs because investors can avoid liability. You might come across yet another business entity structure called a limited liability partnership, or LLP.
For example, if one doctor in a medical practice commits malpractice, having an LLP lets the other doctors avoid liability. Shareholders the owners , a board of directors, and officers have control over the corporation, although one person in a C corp can fulfill all of these roles, so it is possible to create a corporation where you're in charge of everything.
With this type of business entity, there are many more regulations and tax laws that the company must comply with. Methods for incorporating, fees, and required forms vary by state. C corporations are eligible for more tax deductions than any other type of business.
C corporation owners pay lower self-employment taxes. You have the ability to offer stock options, which can help you raise money in the future. C corporations face double taxation: The company pays taxes on the corporate tax return, and then shareholders pay taxes on dividends on their personal tax returns. Owners cannot deduct business losses on their personal tax returns. There are a lot of formalities that corporations have to meet, such as holding board and shareholder meetings, keeping meeting minutes and creating bylaws.
Most small businesses pass over C corps when deciding how to structure their business, but they can be a good choice as your business grows and you find yourself needing more legal protections. The biggest benefit of a C corp is limited liability. Owners who invest profits back into the business as opposed to taking dividends are more likely to benefit under a corporate structure. Corporation formation and maintenance can be complicated, but online legal services can help with these things.
An S corporation preserves the limited liability that comes with a C corporation but is a pass-through entity for tax purposes. No corporate taxation and no double taxation: An S corp is a pass-through entity, so the government taxes it much like a sole proprietorship or partnership.
Like C corporations, S corporations are more expensive to create than both sole proprietorships and partnerships requires registration with the state.
There are more limits on issuing stock with S corps than C corps. You still need to comply with corporate formalities, like creating bylaws and holding board and shareholder meetings. In order to organize as an S corporation or convert your business to an S corporation, you have to file IRS form S corporations can be a good choice for businesses that want a corporate structure but like the tax flexibility of a sole proprietorship or partnership.
A limited liability company takes positive features from each of the other business entity types. Like corporations, LLCs offer limited liability protections. But, LLCs also have less paperwork and ongoing requirements, and in that sense, they are more like sole proprietorships and partnerships. You can elect to have the IRS treat it as a corporation or as a pass-through entity on your taxes. You can choose whether you want your LLC to be taxed as a partnership or as a corporation.
Not as many corporate formalities compared to an S corp or C corp. LLCs are popular among small business owners, including freelancers, because they combine the best of many worlds: the ease of a sole proprietorship or partnership with the legal protections of a corporation.
With a better understanding of how the common business entity types work and their respective pros and cons, you can now determine which type works best for your small business. The best course of action, if you can afford it, is to consult a business lawyer and tax professional on which structure is optimal for you, given where your business is currently and where you hope to take it.
As a starting point, however, there are three general factors to consider when choosing among business entity types: legal protection, tax treatment and paperwork requirements. In the section below, you can see how the entities stack up with regard to each of these factors. Sole proprietorship. Limited Liability Protections? C corporations can become S corporations, sole proprietorships can become LLCs , and so forth.
Make sure you check in with federal, state, and local regulations to fill out the correct paperwork to make that transition. But once your business is established, a good accountant can help ensure all your accounts fall in line with regulations for that entity.
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Your bookkeeping team imports bank statements, categorizes transactions, and prepares financial statements every month. Get started with a free month of bookkeeping. This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post.
Bench assumes no liability for actions taken in reliance upon the information contained herein. Sign up for a trial of Bench. No pressure, no credit card required. For Partners. By Amanda Smith on April 8, Contents The five main entity types Questions to ask when choosing between types of business entities Sole proprietorship Partnerships C corporation S corporation Limited liability company LLC Changing your business entity.
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