Many new businesses start out as sole proprietorships because this is the simplest form of ownership and requires very little paperwork or expense to start up. But for businesses with multiple owners or those needing outside funding, this usually isn't sufficient.
The three most common forms of ownership are Partnerships, Corporations and Limited Liability Companies (LLC's). There are other options, but most businesses use one of these operating forms and each has different treatment of taxes and legal issues for the owners.
This is a relatively easy form of ownership to set up as it only requires an agreement among the partners, which can be verbal or written. In a partnership, the owners manage and control the business and all revenue flows directly through the business to each partner, each of whom are then taxed based on their portion of the income.
The partners are personally liable for debts and any liabilities that result from the operation of the business. When one partner leaves the business, it is dissolved unless there is an agreement in place that allows it to continue.
A business continuation agreement will typically stipulate the terms under which a partner can transfer his or her share of the business for some financial consideration. The same agreement should provide for the transfer of a deceased partner's share so the surviving family receives fair compensation from the remaining partners.
Limited Liability Company (LLC)
The creation of an LLC requires an operational agreement and a filing of articles of organization with the state. Similar to partnerships, owners of an LLC control and manage the company. The company files an information tax return which reports each owner's share of the profits, but does not pay taxes directly. The owners report and pay tax on their personal returns based on their ownership share and the profits reported.
A primary difference between a partnership and an LLC is that LLC's can provide limited liability protection for the owners. This helps to insulate the owners from the debts and liabilities of the company. It is becoming a very popular alternative, as it is relatively easy to set up, usually has lower set-up costs than a corporation and avoids issues around dividends and the double taxation of profits that can occur in corporations.
LLC's are governed by the states in which they are formed and this means that the regulations around setting them up may vary from state to state.
Corporations are legal entities that are created by filing articles of incorporation with the state. Corporations provide protection from liability for the owners and do not have any restrictions on who can own shares or the number of shareholders you can have. This is usually the best bet when you have a large number of investors or for a business considering going public somewhere down the road.
There is a lot of confusion around the question of Sub-S corporations vs. C corporations. They are actually the same type of entity - the difference is in the way they are taxed. All corporations are C-corporations unless you file and receive approval from the IRS to be treated as a Sub-S for tax purposes. This is called electing Sub-S status. There are limitations on the number and type of owners you can have for Sub-S status, so not all corporations are eligible to file taxes on a Sub-S basis.
It is possible to switch from C corporation tax status to S-corporation tax status or vice versa, but there are time limitations about when you can and can't do so. A C corporation is a tax entity in and of itself, so it files a tax return and the corporation is taxed based on business profits. An S-Corp is similar to a partnership or LLC in that it files an information return (Form 1120S) and then the taxable income flows directly to the shareholder owners in proportion to their ownership.
In a C-corporation, an effective "double-taxation" can occur when the corporation pays dividends to owners out of profits which have already been taxed and then the shareholder owners pay tax on the dividend income reported to them.
Which Type is Best?
There is no right answer to that. This article summarizes key differences based on taxation and liability limitations, but there are many factors including your type of business, whether you are seeking funding, how many owners are anticipated, etc., that need to go into your decision. You can consult with an attorney and tax advisor to make the decision or use a specialty online service to get more information if you wish to do it yourself.
Ultimately the form of business ownership selected comes down to the owners' level of concern over management control, liability exposure, tax issues and business transfer issues. Because of the tax and legal implications involved, it is important to do the necessary due diligence before selecting an ownership form.