Best Type of Corporation for Small Business
It can be a difficult but important decision as there are numerous considerations to take into account with the pros and cons of each choice.3 min read
Choosing the best type of corporation for small business can be a difficult but important decision as there are numerous considerations to take into account with the pros and cons of each choice. The type of entity you choose will have both tax and liability consequences for your business in the future. The types of entities for a small business are:
- Sole proprietorship
- C corporation
- Limited liability company (LLC)
- S corporation
A sole proprietorship is the most common way that a small business is set up. It is the simplest entity to set up, and there is no state filing required aside from obtaining a business license. In a sole proprietorship, the business owner is personally liable for debts, losses, and liabilities for the business. This makes it simple when tax season rolls around, as you can file all profits and losses for the business on your personal tax form.
Since the business owner is personally liable, there is a risk in being a sole proprietorship. If there is legal action, the business owner's personal assets are also at risk. The business owner can be held liable also for any actions of their employees.
A partnership is a similar arrangement as a sole proprietorship, except that all profits, losses, and liabilities are shared between two or more partners, instead of one single business owner. A partnership can be either a general partnership or a limited partnership. In a general partnership, all profits, losses, and liabilities are spread equally. In a limited partnership, there may be some partnerships with a lower percentage of profit and liability. This is often determined by the ownership share in the business.
The biggest drawback to the partnership arrangement is the joint and individual liability. Just as in a sole proprietorship, you have individual liability for the business. However, in a partnership, you are also liable for the actions of your partners as well. But on the other hand, you do also have the skills and experience of others to assist in all the costs and decisions of business ownership.
A corporation is owned by shareholders instead of an individual owner. It is the entity of the corporation that is then liable for any liabilities and debts of the business. Most corporations tend to be a larger business in part due to the difficulty in starting a corporation. To set up a corporation, you would need the assistance of an accountant and likely a legal professional to make sure all the legal and tax requirements are met.
Corporations have additional yearly requirements by local, state, and federal jurisdictions which will increase the amount of administrative work that is needed to be done. Corporations also can sometimes be hit by taxation on two levels — both when the profit is reported and when the profit is paid out to the shareholders.
There are also many benefits to having a corporation. Probably the most important benefit is the limited liability. The corporation itself is liable for any legal trouble, debt, or liabilities. Even the shareholders typically are not held liable beyond the cost of their particular shares.
Since the corporation is its own separate entity, the corporation files its own taxes. The shareholders and owners also file their own separate taxes.
An S corporation is formed off of a corporation if the shareholders vote to change it. An S corporation still maintains the limited liability, but the owners may not be completely immune to personal liability. The taxation reverts to that similar to a partnership in which the shareholders report the income on their own personal income taxes.
Limited Liability Company (LLC)
An LLC is a best of both worlds solution between a partnership and a corporation. It is much easier to start than a corporation and is also not recognized as a corporate entity, so it does not need to pay corporate tax. The owner's of the LLC, similar to a partnership, report all profits and losses to their individual income tax.
Similar to a corporation though, an LLC offers limited liability protections in that the members are protected from personal liability. There are not as many requirements in record keeping for LLCs as there are for corporations. LLCs also have an advantage over sole proprietorships or partnerships in obtaining business loans. The biggest drawback to an LLC is that members are considered self-employed and are required to pay self-employment taxes.
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