Truth 19. Choosing a form of business ownership
When you launch a business, you need to choose a form of legal entity. Sole proprietorship, partnerships, corporations, and limited liability companies are the most common. There is no single form of business ownership that works best in all situations.
Sole proprietorship—The simplest form of business ownership is the sole proprietorship,[1] which involves one person. The person and the business are essentially the same. The biggest advantage of the sole proprietorship is that the owner maintains complete control over the business. The biggest disadvantage is that the sole proprietor is responsible for all the liabilities of the business. If a sole proprietor’s business is sued, the owner could theoretically lose all the business’s assets along with personal assets. As a result, a sole proprietorship is not a good choice for most new businesses.
Advantages of a sole proprietorship:
Creating one is easy and inexpensive.
The owner maintains complete control of the business and profits.
It is not subject to double taxation (explained later).
Disadvantages of a sole proprietorship:
Liability on the owner’s part is unlimited.
The business ends at the owner’s death or loss of interest in the business.
The liquidity of the owner’s investment is low.
Partnerships—If two or more people start a business, they must organize as a partnership, corporation, or limited liability company. Partnerships are organized as either general or limited partnerships. The primary advantage of a general partnership is that the business isn’t dependent on a single person for its success. The primary disadvantage of a general partnership is that the individual partners are liable for all the partnership’s obligations. As a result, a general partnership is typically not a good choice for a new business.
Advantages of a general partnership:
Creating one is easy and inexpensive.
Business losses can be deducted against the partner’s other sources of income.
Disadvantages of a general partnership:
Liability on the part of each general partner is unlimited.
Disagreements among partners can occur.
The liquidity of each partner’s investment is low.
The second form of partnership is the limited partnership. The primary difference between the two is that a limited partnership includes two classes of owners: general partners and limited partners. The general partners are liable for the obligations of the partnership, but the limited partners are liable only up to the amount of their investment.
Corporations—A corporation is a separate legal entity organized under the authority of a state. Corporations are organized as either C corporations or subchapter S corporations. A C corporation is a legal entity that is separate from its owners. The major advantage of a corporation is that it shields its owners from personal liability for obligations of the business. The major disadvantage is that a corporation is subject to double-taxation—the corporation is taxed on its net income and, when the same income is distributed to shareholders in the form of dividends, it is taxed again on the shareholder’s personal income tax returns.
Advantages of a C corporation:
Owners are liable only for the obligations of the corporation up to the amount of their investment.
No restrictions on the number of shareholders.
The ability to share stock with employees through incentive plans can be a powerful form of employee motivation.
Disadvantages of a C corporation:
Setting up and maintaining one is more difficult and expensive than a sole proprietorship or general partnership.
Business losses cannot be deducted against the shareholder’s other sources of income.
Income is subject to double taxation.
A subchapter S corporation combines the advantages of a partnership and a C corporation. It is similar to a partnership in that the profits and losses of the business are not subject to double taxation. It is similar to a corporation in that the owners are not subject to personal liability for the behavior of the business. The major disadvantage of the subchapter S corporation is that it is limited to 100 shareholders, which can be a drawback when trying to raise money from a large pool of investors.
Limited liability company—The limited liability company (LLC) is a form of business organization that is gaining popularity in the United States. The main advantages of the LLC are that it is more flexible than a subchapter S corporation in terms of number of owners and tax-related issues, and all members enjoy limited liability. The main disadvantages are that it is relatively complex to set up, and in some states the rules governing the LLC vary.
Advantages of a limited liability company:
Members are liable for the obligations of the business only up to the amount of their investment.
The number of shareholders is unlimited.
There is no double taxation.
Disadvantages of a limited liability company:
Setting up and maintaining one is more difficult and expensive than the other legal entities.
Some of the regulations governing LLCs vary by state.
Some states levy a franchise tax on LLCs, which is essentially a fee the LLC pays the state for the benefit of limited liability.
According to a study published by the Kauffman Foundation, 35.5% of businesses start as sole proprietorships, 30.5% start as LLCs, 20.1% start as subchapter S corporations, 7.9% start as C corporations, and 5.7% start as limited or general partnerships.[2] It is money well spent to consult with a small business accountant or attorney to select the form of business ownership most appropriate for your start-up.