Types of business entities
/There are several types of business entities, each designed for different situations. The type of entity chosen has a significant impact on the taxes paid and the amount of investors’ personal assets placed at risk. The primary types of business entities are as follows, along with their advantages and disadvantages.
Sole Proprietorship
A sole proprietorship is a business that is directly owned by a single individual. It is not incorporated, so that the sole owner is entitled to the entire net worth of the business, and is personally liable for its debts. The individual and the business are considered to be the same entity for tax purposes.
Advantages of a Sole Proprietorship
The advantages of a sole proprietorship are that it is simple to organize, tax filings are easy, there is no double taxation, and the owner has complete control over the business. These advantages attract many small business owners who are just starting out. If their business proves to be viable, then they switch to one of the other types of business entities described later in this article.
Disadvantages of a Sole Proprietorship
The main disadvantage of a sole proprietorship is that the owner has unlimited liability for the debts of the business. This could result in the owner being wiped out if a creditor or lender to the business decides to pursue the owner’s personal assets in order to be paid back. Other disadvantages are that self-employment taxes must be paid by the owner, and the only provider of equity to the business is the sole owner (which limits funding sources).
In brief, the unlimited liability imposed by a sole proprietorship is usually considered to completely outweigh all other aspects of this form of ownership. Its ability to avoid double taxation can be matched by an S corporation (as described later), but the S corporation also keeps the owner from being personally liable for the obligations of the business.
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Partnership
A partnership is a form of business organization in which owners have unlimited personal liability for the actions of the business, though this problem can be mitigated through the use of a limited liability partnership. The owners of a partnership have invested their own funds and time in the organization, and share proportionally in any profits earned by it. There may also be limited partners in the business, who contribute funds but do not take part in day-to-day operations. A limited partner is only liable for the amount of funds he or she invested in the entity; once those funds are paid out, the limited partner has no additional liability in relation to the activities of the partnership. If there are limited partners, there must also be a designated general partner that is an active manager of the business; this individual has essentially the same liabilities as a sole proprietor.
A partnership does not pay income taxes. Instead, the partners report their share of the partnership's profit on their personal income tax returns. Because partners must pay income taxes on their shares of partnership income, they typically require some distribution of cash from the partnership in order to pay their taxes.
In those instances where a partnership recognizes a loss during its fiscal year, the share of the loss recognized by each partner in his or her personal tax return is limited to the amount of the loss that offsets each partner's basis in the partnership. If the amount of the loss is greater than this basis, the excess amount must be carried forward into a future period, where it can hopefully be offset against the future profits of the partnership.
A key advantage of a partnership is that, with many partners, a business has a much richer source of capital than would be the case for a sole proprietorship. In addition, if there is more than one general partner, it is possible for multiple people with diverse skill sets to run a business. And a final advantage is that there is no double taxation. However, there are also several disadvantages. One is that the general partners have unlimited personal liability for the obligations of the partnership. Another downside is that a partner’s share of the ordinary income is subject to the self-employment tax.
The risk associated with a partnership arrangement works well for limited partners, since their losses are limited to their own investments in the business.
Corporation
A corporation is a legal entity whose investors purchase shares of stock as evidence of their ownership in it. A corporation acts as a legal shield for its owners, so that they are generally not liable for the corporation's actions. A corporation pays all types of taxes, including income taxes, payroll taxes, sales and use taxes, and property taxes.
One advantage of a corporation is that shareholders are only liable up to the amount of their investments. Another advantage is that a publicly-held corporation in particular can raise substantial amounts by selling shares or issuing bonds. And finally, a shareholder can sell shares in a corporation to a third party. However, there are also several disadvantages related to corporations. One is that this entity and its shareholders are subject to double taxation. Another concern is that the various types of income and other taxes that must be paid can add up to a substantial amount of paperwork.
There are two main types of corporation, which are the C corporation and S corporation.
C Corporation
The default form of corporation is the C corporation, which is taxed as a separate entity. Distributions to shareholders are made in the form of dividends. The C corporation structure is heavily used, because it can be owned by an unlimited number of shareholders. This gives it an unrivaled ability to attract capital from investors.
S Corporation
A variation on the standard corporation model is the S corporation. An S corporation passes its income through to its owners, so that the entity itself does not pay income taxes. The owners report the income on their tax returns, thereby avoiding the double taxation that arises in a regular C corporation.
Limited Liability Company
A limited liability company (LLC) combines the features of corporations and partnerships, which makes them an ideal entity for many businesses. One advantage of an LLC is that the liability of investors is limited to the amount of their investments in the LLC. Another advantage is that an LLC can be structured so that the income earned by the business flows directly through to investors. A third advantage is that an LLC can be run by professional managers, rather than a general partner. Furthermore, there is no limitation on the number of investors in an LLC. And finally, an LLC can issue multiple classes of stock. Offsetting these advantages are two problems, one of which is that each state has implemented different rules regarding how an LLC is structured and operated. Another concern is that there will be annual government fees charged to maintain an LLC entity.
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