Many factors should be considered when choosing the best form of business ownership or structure. The choice you make can impact multiple aspects of your business, including taxes, liability, ownership succession, and others.
This lesson provides an overview of the various forms of business ownership including sole proprietorship, partnership, corporations, and limited liability companies. It includes excerpts from the Small Business Administration (SBA) Program Office guide on business structure.
Why is this important?
One of the first decisions that you will have to make as a business owner is how the company should be structured. This decision will have long-term implications, so consult with an accountant and attorney to help you select the form of ownership that is right for you. In making a choice, you will want to take into account the following:
- Your vision regarding the size and nature of your business.
- The level of control you wish to have.
- The level of “structure” you are willing to deal with.
- The business’s vulnerability to lawsuits.
- Tax implications of the different ownership structures.
- Expected profit (or loss) of the business.
- Whether or not you need to re-invest earnings into the business.
- Your need for access to cash-out of the business for yourself.
Sole proprietorships
The vast majority of small businesses start out as sole proprietorships. These firms are owned by one person, usually the individual who has day-to-day responsibilities for running the business. Sole proprietors own all the assets of the business and the profits generated by it. They also assume complete responsibility for any of the liabilities or debts. In the eyes of the law and the public, the sole proprietor is one in the same with the business.
Advantages of a Sole Proprietorship:
- Easiest and least expensive form of ownership to organize.
- Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.
- Sole proprietors receive all income generated by the business to keep or reinvest.
- Profits from the business flow directly to the owner’s personal tax return.
- The business is easy to dissolve, if desired.
Disadvantages of a Sole Proprietorship:
- Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
- May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.
- May have a hard time attracting high-caliber employees or those who are motivated by the opportunity to own a part of the business.
- Some employee benefits such as owner’s medical insurance premiums are not directly deductible from business income (only partially deductible as an adjustment to income).
Partnerships
In a Partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, future partners will be admitted into the partnership, partners can be bought out, and what steps will be taken to dissolve the partnership. Yes, it’s hard to think about a breakup when the business is just getting started, but many partnerships dissolve during times of crisis, and unless there is a defined process, there will be even greater problems. They also must decide up-front how much time and capital each will contribute, etc.
Advantages of a Partnership:
- Relatively easy to establish; however time should be invested in developing the partnership agreement.
- With more than one owner, the ability to raise funds may be increased.
- Profits from the business flow directly through to the partners’ personal tax returns.
- Prospective employees may be attracted to the business if given the incentive to become a partner.
- The business usually will benefit from partners who have complementary skills.
Disadvantages of a Partnership:
- Partners are jointly and individually liable for the actions of the other partners.
- Profits must be shared with others.
- Because decisions are shared, disagreements can occur.
- Some employee benefits are not deductible from business income on tax returns.
- The partnership may have a limited life; it may end upon the withdrawal or death of a partner.
Types of Partnerships that should be considered:
General Partnership
Partners divide responsibility for management and liability as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
Limited Partnership and Partnership with limited liability
Limited means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions. The limited partners invest capital in the company and share in the profits, but take no part in the daily operation of the business. Their liability, should the company be sued, is limited in proportion to the amount of capital that they invest. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.
Joint Venture
Resembles a general partnership, but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such and distribute accumulated partnership assets upon dissolution of the entity.
Corporations
A corporation chartered by the state in which it is headquartered is considered by law to be a unique entity, separate and apart from those who own it. A corporation can be taxed, it can be sued, and it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes.
Advantages of a Corporation:
- Shareholders have limited liability for the corporation’s debts or judgments against the corporation.
- Generally, shareholders can only be held accountable for their investment in stock in the company. (Note however, that officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.)
- Corporations can raise additional funds through the sale of stock.
- A corporation may deduct the cost of benefits it provides to officers and employees.
- Can elect S corporation status if certain requirements are met. This election enables the company to be taxed similarly as a partnership.
Disadvantages of a Corporation:
- The process of incorporation requires more time and money than other forms of organization.
- Corporations are monitored by federal, state and some local agencies, and as a result may face more paperwork to comply with regulations.
- Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible from business income; thus the corporation and the shareholder is taxed (this is commonly known as “double taxation’).
Subchapter S corporations
A Subchapter S Corporation refers to a tax election only; this election enables shareholders to treat the earnings and profits as distributions and have them pass through directly to their personal tax return. The catch here is that the shareholder, if working for a company that makes a profit, must pay him/herself wages that must meet standards of “reasonable compensation.” This can vary by geographical region as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit. If you do not do this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for the payroll taxes on the total amount.
Limited liability company (LLC)
The LLC is a relatively new type of hybrid business structure that is now recognized in most states. It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Formation is more complex and formal than that of a general partnership.
The owners are members, and the duration of the LLC is usually determined when the organization papers are filed. The time limit can be extended, if desired, by a vote of the members at the time of expiration. LLCs must not have more than two of the four characteristics that define corporations: Limited liability to the extent of assets, continuity of life, centralization of management, and free transferability of ownership interests.
Special structures
The following business structures are available in some states, but not all.
Limited Liability Partnerships (LLP) are organized to protect individual partners from personal liability for the negligent acts of other partners or employees not under their direct control. Although LLPs are not recognized by every state, it is recognized in Hawaiʻi. Partners report their share of profits and losses on their personal tax returns.
Limited Partnership (LP) have complex formation requirements, and require at least one general partner who is fully responsible for partnership obligations and normal business operations. The LP also requires at least one limited partner, often an investor, who is not involved in everyday operations and is shielded from liability for partnership obligations beyond the amount of their investment. LPs do not pay tax, but must file a return for informational purposes; partners report their share of profits and losses on their personal returns.
Non-Profit Corporations are formed for civic, educational, charitable, and religious purposes and enjoy tax-exempt status and limited personal liability. Non-profit corporations are managed by a board of directors or trustees. Assets must be transferred to another non-profit group if the corporation is dissolved.
Registering your business
Once you decide on the name and legal form of your business, you can register your business with the State. In Hawaiʻi you can register your business online at the Hawaiʻi Business Express website (https://hbe.ehawaii.gov/BizEx/home.eb). It’s easy to use, they provide step by step instructions on each page, and once you fill out basic information it will prefill similar information on other forms. You simply create an account, file the application and pay online using a credit card. If you decide that you don’t want to use the online system, you can complete and mail or walk in the required forms which you can print out from the Dept. of Commerce and Consumer Affairs website at http://cca.hawaii.gov/breg/registration/registration-form-info/.
Before you register
Once you are ready to begin the process of registering your business, you will need to have/know the following information about the business entity you would like to register.
- The business entity type. i.e., Corporation, Limited Liability Company, Sole Proprietorship, etc.
- Date the new business is going to start in Hawaiʻi.
- Date of the first payroll in Hawaiʻi (if applicable).
- Names, addresses, phone numbers and FEIN’s or SSN’s of proprietors, partners, corporate officers, LLC members and registered agent.
- The business location(s).
- Brief description of the business activity.
- Name and telephone number of person submitting the registration.
- Form of payment (Visa, Mastercard, Discover’s Card, and American Express).
- Many businesses will need to obtain a Federal Employer Identification Number (FEIN) from the Internal Revenue Service. This is true if you are creating a corporation, limited liability company, limited partnership, limited liability partnership, OR a sole proprietorship with employees.
Keep in mind that if you start the process and don’t have time to finish, the system will save whatever you’ve worked on so you can always login and continue registering. Also, a benefit of using the online system is that by asking certain questions, it will either create additional forms you may need or notify you of additional requirements. For example, if you indicate that you will have employees, the system will also apply for a state withholding number (from the Dept. of Taxation) and an unemployment insurance number (from the Dept. of Labor).