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It’s exciting to open a small business. You have passion for your product or service, and motivation to work hard to make it successful. It may be tempting to dive in head first and leave some of the details for later. However, how you classify your business up front will affect you in may ways down the road. If you’re confused about whether you should consider sole proprietorship, partnership, corporation, or limited liability corporation (LLC), here are some of the advantages and disadvantages of each.
A sole proprietor owns all assets, keeps all profits, and has complete responsibility for all of the liabilities and debts of the business. Most small businesses start this way, especially if they do not great personal liability in their profession. Sole proprietorships are the easiest form of business to set up from a legal perspective, and offer the owner the greatest freedom in making decisions.
There are some drawbacks, however. Consider that you are personally responsible for any liabilities or debts that the business incurs. You do not have protection against lawsuits filed against your company, so if you are in a high risk industry, you need to carefully consider whether or not you could personally survive a large setback. There are tax implications as well. Depending on your expected income, you may pay taxes at a higher rate than if you incorporated. Not all expenses (such as owner’s medical insurance premiums) are fully deductible. If you choose to bring in a partner later and intend to convert your sole proprietorship to a corporation, there could be additional tax implications that your accountant can explain to you in further detail.
Legally similar to a sole proprietorship, a partnership is a sharing of ownership between two or more parties. Partnerships are relatively easy to set up. Unlike a sole proprietor, additional funds may be easier to come by with more people involved in the venture. Partners share in the profits based on their initial agreement, and share the responsibilities for any liabilities or debts.
When entering into a partnership, it is extremely important to have a clear legal agreement executed and reviewed by an attorney to avoid problems or conflicts in the future. Decisions are generally shared, as are profits, which can lead to disagreements. And like a sole proprietorship, there may be tax implications that can affect your business in the future.
Generally speaking, incorporating your business creates a separate and unique entity for your business. It creates a type of protection for the businessperson in that the corporation has the main responsibility for liabilities and debts (but note that there are still certain actions that can transfer some personal liability to the officers). Depending on income, corporations may be less in taxes than a sole proprietor. Corporations may have additional deduction opportunities, such as payment of benefits to employees and officers.
It may sound ideal, but incorporating takes time and money to accomplish. Corporation are more closely monitored by federal, state (and possibly local) agencies, and in general have more paperwork to comply with regulations. Again depending on income, taxes can be higher, and dividends paid to shareholders are not deductible, which could lead to double taxation.
Limited Liability Corporations (LLCs)
LLCs are attractive because they allow the business and its owners to reap some of the benefits of both sole proprietorships/partnerships and corporation. As with a corporation, owners have limited personal liability for the business liabilities and debts. Profit and loss can be allocated differently than the ownership percentages. IRS rules allow for LLCs to choose their tax structure – either sole proprietorship/partnership rates, or corporate rates.
LLCs are more complicated to establish than sole proprietorships or partnerships. As it is a relatively new concept in the business world, state laws vary and may not always reflect federal tax changes in a timely manner. LLCs are limited to enjoying only two of the four characteristics that define corporations.
Unless your business venture is extremely simple and uncomplicated, you may want to contact your certified public accountant and/or attorney to assist you in making the right decision as to how to classify your business. Investing in professional advice in the beginning can save a lot of headaches down the road.