When looking to start a business it is important to understand the different forms of businesses that are available to choose from. Each form is suited for a specific type of business to help structure a company’s operations.
Sole Proprietorship – As the name suggests a sole proprietorship owner has complete control of their company and receives all the profits that the business generates. The sole proprietor is personally responsible for all debts that the business incurs. This means that in the event that the business cannot repay its debts, the owner is liable to pay the outstanding debts. There is no separation between the business and the owner, all debts and profits belong to the sole proprietor. Therefore when a sole proprietorship files taxes they are filed under the owner’s personal income tax return. Sole proprietorships have limitations in their ability to raise funds as banks will only lend to sole proprietorships in a limited capacity due to the greater risk involved.
Partnership – A partnership is an agreement between two or more individuals to form a business. Partnerships rely on a partnership agreement to dictate the ownership percentage, income distribution, financial liability, roles, responsibilities, and operations. Profits and losses are distributed between partners based on the partnership agreement. Partnerships allow for flexibility with different members taking unique roles within the business. There are two forms of partnerships:
- General Partnership – All owners take responsibility for the profit and loss of the company.
- Limited Partnership – A limited partnership has at least one general partner who takes responsibility for all profit and loss of the company, and one limited partner. The limited partner is an investor that does not get involved with the day to day operation of the company. A limited partner is not liable for the debts of the company. Limited partnerships allow investors to invest in businesses without taking on any additional risk beyond the initial investment.
A partnership files taxes under each partner’s individual income tax return based on the partnership agreement. With both sole proprietorships and partnerships, the lifespan of the business is limited. The business is dissolved in the event that one of the owners die, additionally, the partnership agreement can limit the partnership to a set amount of time. Owners in a partnership can only sell their shares in the business with the consent of the partners. Both Sole proprietorships and partnerships have the advantage of not needing to file with the state government when forming the business. This removes the costs of filing an article of organization that LLC’s are required to file when forming a business. An additional benefit is that partnerships start immediately from the time that the agreement is made, as there is no need to wait for state approval.
Corporation – A corporation is a legal entity, this means that in regards to business matters a corporation can conduct business as an independent entity. This creates a separation between the owners and the corporation. A corporation is formed when the owners do the following: 1. Files articles of incorporation. 2. Appoint a board of directors. 3. Create bylaws. The article of incorporation is similar to the partnership agreement as it lays out the contract between the owners and the corporation. It states the name of the corporation, what type of business it operates, and where it is located. The contract issues shares of ownership to the shareholders of the corporation. Just as in the partnership agreement, the owners allocate shares of the company to each member based on the agreement. The bylaws are the responsibilities and roles of the members of the corporation. A board of directors is elected to take the place of the owners in the operation and management of the business. The board of directors is responsible for the major decisions of the corporation, ensuring that they meet the interests of the shareholders.
A corporation’s lifespan has no limit and can exist indefinitely, the corporation is its own entity and can conduct business fully independent from its owners. Unlike in partnerships, corporations do not dissolve in the event of the death of an owner. Being that corporations are their own entity they file taxes independent of the owners, they are subject to corporate tax rates that differ from personal tax rates. This separate tax creates double taxation, where the corporation pays taxes and then the owner pays taxes on the share of profits he receives. Owners are not liable for a corporation’s debts as it is a separate entity. Payments from a corporation’s profits are distributed to owners based on their percentage of ownership, these payments are referred to as dividends. The ownership of a corporation is referred to as shares or stock. There are two types of corporations in regards to ownership: close corporation, and a public corporation. Public corporations are corporations whose shares are sold openly to the public. Close corporations are corporations consisting of a closed group with a small number of owners who control all aspects of the company. Corporations can sell portions of the company to investors in order to raise funds, this gives them an added advantage over a partnership as there are multiple avenues to raise capital.
A hybrid of a corporation and a partnership is known as an LLC (limited liability company). An LLC has the benefit of a partnership with regards to taxes, as the company can file once under the owner’s personal income tax return. This removes the double taxation issue that corporations must pay. An LLC also has the benefit of limited liability that corporations enjoy, protecting the owners from incurring personal debts of the company.
Each form of business comes with pros and cons, an accountant should be consulted for an in-depth explanation when forming a company.