All about business formation: Important steps you need to know about
The number of new businesses formed in the United States surged in the summer of 2020. However, business formation is not as easy as it sounds.
There are tax and legal considerations to take into account, like which business model to adopt as you start a business. The way in which your business is formed will determine your personal liability, your business’s day-to-day operations, how taxes are paid, your ability to raise money, the paperwork you need to file, and other important matters. So it is wise to learn the essentials of business formation before you start your business.
There are five main legal organizational forms:
- Sole proprietorship
- Limited liability company (LLC)
The first four are the most common business structures, so they’re what we’ll look at more closely here.
A sole proprietorship is owned and run by only one individual and there is no legal distinction between the individual owner and the business. The business itself does not file a tax return. Instead, the business income or loss is reported through the owner’s personal tax return through a Schedule C or Form 1040. It’s the simplest business structure to form, with very little formality and costs.
A sole proprietorship gives the owner full control of the business. However, this also means that the owner is personally exposed to business risk and is fully responsible for all liabilities incurred by her business. It’s difficult to raise money, too, as investors do not normally invest in sole proprietorships.
There are more than 23 million sole proprietorships in the United States, representing 73% of all businesses, and they are set to take off in 2022.
A general partnership is an association between two or more people to own and operate a business for profit. It’s also relatively easy to form, but a legal formality is needed through a partnership agreement, which stipulates partnership terms for ownership percentages, management rights, profit/loss sharing, and dissolution terms, among many things.
A partnership is a tax-reporting but not a tax-paying entity. This means that the partnership must file annual information returns with the Internal Revenue Service (IRS) through Form 1065 to report its income or losses from operations, but each partner pays taxes based on their share of the profits or loss through their personal tax returns.
Like sole proprietors, partners have unlimited personal liability and are jointly liable for all business obligations. Although it is easy to form and requires minimal costs, it can lead to management and oversight issues, especially without a good partnership agreement. There are more than 7.4 million partnerships in the United States today.
Limited Liability Company (LLC)
A limited liability company (LLC) is a hybrid of the sole proprietorship, general partnership, and corporation to protect business owners’ limited liability. LLC owners are called members and they may be individuals, corporations, other LLCs, and foreign entities. Like the partnership, an LLC entity is only required to file an informational tax return while the profits or losses pass through the members who pay taxes through their personal tax returns.
Unlike the partnership, though, LLC members are protected from business debts, claims, and other liabilities, thus the “limited liability” term. Creditors can’t reach the personal assets of LLC members. To form an LLC, filing fees ranging from $100 to $800 are paid, and articles of organization are submitted, so look into LLC cost by states to make sure that you’re paying the right amount.
Some states also require the submission of an operating agreement which usually includes the ownership interest of each member, member rights and responsibilities, member voting power, profit and loss allocation, management structure, and a buy-sell provision.
LLCs provide the benefits of limited liability for owners even as it allows an unlimited number of members and taxation at the individual level. However, at the state level, LLCs might be subject to additional taxes, and each member’s share of profits represents taxable income even if it hasn’t been distributed to the member. Based on a 2017 survey by the National Small Business Association, 35% of small businesses registered themselves as LLCs.
Corporations are the most complex business structures. They are legal entities in themselves and are separate and distinct from their owners or shareholders. They can enter into contracts and assume responsibilities like tax payments separate from the shareholders.
Corporations are most appropriate for established businesses with multiple employees, also for businesses that sell products or services that could expose them to potentially huge liabilities. Ownership of a corporate business is designated by issuing shares of stock. Corporations are more complex legal entities to create and have more legal and accounting requirements than sole proprietorships, general partnerships, and LLCs.
Corporations provide the benefits of limited liability for shareholders, “immortality” (does not terminate upon shareholders’ deaths), and capital-raising capacity as it is the form that’s most preferred by investors. However, it’s very rigorous and costly to maintain, requiring a high level of governance and oversight by a board of directors, and subjects earnings to double taxation since income is taxed at the corporate entity level as well as the individual level upon earnings distribution to shareholders. There are more than 1.7 million traditional corporations in the United States.
Choosing one for your business
In deciding on the best structure for your business, choose a business structure that gives you the right balance of benefits and legal protections, as well as the costs you are willing to incur in the adoption of a particular business form.
Three main factors to be considered are your need for liability protection, your need to attract investors, and the need for simplicity or complexity of forming your business. Businesses that carry any amount of risk need liability protection. LLCs and corporations are able to provide these, while sole proprietorships and partnerships don’t.
If your business carries only very low risk or has a low chance of liability for financial loss, with a small customer base, and is an offshoot of a hobby or personal interest, then it would probably be best to start out as a sole proprietorship or general partnership.
However, if your business has a large customer base, with the potential for immediate and sustainable profit, but also with the potential for increased risk or loss, and would stand to benefit from unique tax options, it is better to form your business as an LLC or corporation. LLCs and corporations provide you with not only personal liability protection but also tax benefits, increased credibility, and the ability to raise capital from investors.
The best business structure for your enterprise depends on your business’s specific needs and characteristics. Small businesses often use sole proprietorship, general partnership, and LLC structures. The LLC is most recommended, though, because they are not only simple to create and operate, but also provide limited liability protection and pass-through taxation at the individual level.
It is also recommended to consult with an accountant and an attorney for the detailed tax and legal consequences of the legal structure you intend to adopt for your business.