If you are planning on starting your own business, you may be wondering how you should structure it. There are basically four types of business structures: Sole proprietorship, Partnership, Limited Liability Company (LLC), and an “S” or “C” Corporation. Let’s look at some advantages and disadvantages of these different types of business structures.
Sole Proprietorship is just what it sounds like—one owner. Your business may start out as a sole proprietorship and morph into something else along the way or may remain a sole proprietorship for the life of the business. There are no government filings required for a sole proprietorship business. You do not need to register with the IRS (although you can) or file any type of government paper.
If you are a sole proprietor, you will likely have a Profit or Loss from Business form (Schedule C) that accompanies your personal tax return. The income or loss of your sole proprietorship business is reported on your personal tax return. You have unlimited personal liability with a sole proprietorship business, however, you also have absolute control over the business. Investors are unlikely to invest in a business that is organized as a sole proprietorship.
A partnership can be between two or more people. Like a sole proprietorship, there is little formality, but a written partnership agreement is definitely encouraged. Such an agreement would formalize the rules for sharing of profits and losses, as well as layout the percentages of ownership, the terms of dissolution, should one partner want out, and management rights and responsibilities. Partnership agreements should also set forth any capital contributions as well as bookkeeping methods and responsibilities.
A partnership reports taxes but does not pay taxes. Using form 1065, income and losses are reported to the IRS then those profits or losses are passed through to the owners. Each owner then pays his or her share of taxes necessary on the profit or loss. Like a sole proprietor, partners in a business generally have unlimited personal liability.
LLC (Limited Liability Corporation)
An LLC lies somewhere between a corporation and a partnership/sole proprietorship. The owners of an LLC are known as “members.” These members can include individuals, other LLCs, foreign entities, and corporations.
For tax purposes, an LLC is considered a pass-through entity. This means the income from the business passes through the business to LLC members. These members then report their share of profits or losses on their own individual tax returns—similar to a partnership.
The primary benefit of an LLC is that the members are protected from personal liability for business debts and claims. This means that in the event the business is sued or owes money, only the business assets are at risk, rather than the individuals’ assets.
A filing fee must be paid to establish an LLC, and Texas requires that a certificate of formation be filed by the person incorporating the LLC, which will identify the governing person(s) and the LLC’s registered agent. It is also advisable to have a company agreement, which would set forth allocation of profit and loss, the rights and responsibilities of members, the voting power and ownership interests for each member, buy-sell provisions, and the structure of management. An LLC can subject the members to additional state taxes, which can be one downside.
S-Corporations and C-Corporations
S-Corporations and C-Corporations are the most complex business structure. Corporations are separate, independent, legal entities, apart from those who own them or run them. Corporations have the ability to enter into a contract, but also have specific responsibilities—i.e., the payment of taxes for the corporation. Ownership in a corporation is designated by the issuance of stock shares.
Texas law establishes the creation of corporations in the same way as creating an LLC – by filing a certificate of formation. The corporation then can make an election with the IRS as to whether it wishes to be governed under Subchapter C or Subchapter S.
A corporation that is governed under Subchapter C, or a C-Corporation, is a separate, taxpaying entity from its shareholders that files its own tax return. Shareholders must pay personal income tax on corporate profit distributions.
A corporation that is governed under Subchapter C, or a S-Corporation, passes corporate income, losses, deductions, and credits to shareholders for the purpose of federal taxes. Shareholders report that income or loss, paying federal income tax and avoiding double taxation.
It can be very beneficial to speak to a knowledgeable business attorney prior to deciding how to structure your business.
Contact Our Houston Business Lawyers
Starting your own business is an exciting journey for most entrepreneurs. It takes a considerable amount of time, dedication, and passion to do. It also takes a lot of planning and forethought. At Roger G. Jain & Associates, P.C., we know how to help you choose the business formation that is best for you. We can also be with you as your business grows, protecting you from disputes and harmful legal battles. Call at (713) 981-0600 or fill out our confidential contact form to learn more about your legal options.