When it comes to creating a legal entity for business or investment purposes there are several options. From Limited Liability Companies (LLC) and Partnerships (LLP) to C and S Corporations, this article will evaluate the pros and cons of the most widely used options.
The example of sole proprietorship is presented in order to serve as contrast with other ways of business ownership or participation. Sole proprietorship is the simplest and easiest way for an individual to create and run a small business. Under this structure there is little paperwork, particularly when compared to other forms of incorporation. The profits or losses generated from a sole proprietorship business are reported directly on the proprietor’s individual tax return. In this sense, sole proprietorships avoid double taxation because their financial performance is considered to be individual income. The main drawbacks of sole proprietorships stem from the fact that they are tied to the individual who operates the business. Therefore, businesses in the form of sole proprietorships tend to cease operating when the owner stops working. Furthermore, because sole proprietorships do not create a separate legal entity, the owner is personally liable for any losses or debts incurred by the business.
A General Partnership is similar to a sole proprietorship in the sense that the partners do not formally create a new legal entity for their business. Rather, the general partners outline a business agreement in which all partners have equal responsibilities and benefits. Therefore, the profits and losses from general partnerships are passed to the general partners and taxed at the individual level. Likewise, the general partners are all personally liable for any losses or debts incurred by the business.
In an LLC or LLP, the limited partners or investors of the business are only liable for an amount no greater than their respective investments into the business. Unlike general partnerships and sole proprietorships, LLCs and LLPs do create an independent legal entity for the business. Therefore, the limited partners and members of the company are protected from unlimited liability. However, an advantage to these two forms of limited liability businesses is that they do allow for flow-through taxation at the individual level, thus avoiding corporate taxation.
As a way of managing a business, corporations create separate and independent legal entities. This means that the corporation itself, not its owners or members, is responsible for the debts incurred by the business. Therefore, in the case of default, creditors can only lay claim to assets that are owned by the legal entity that is the corporation. In this regard, corporations offer their members and owners full liability protection. Similarly, because they are independent legal entities, corporations can raise capital by selling shares.
Corporations are the most time consuming and complex method to create a business. However, the legal process provides the business with a life of its own and, if profitable, it can be sold in the future. There are two main types of legal incorporation, S-corporations and C-corporations. The great majority of corporations are C-corps; their main feature is that there is no limit to the amount of shareholders participating in the corporation. However, C-corps are subject to double taxation. This means that their income is first taxed at the corporate tax rate and then taxed again when it reaches the individual in the form of dividends or salaried compensation. On the other hand, S-corps can avoid double taxation and pass income directly through to shareholders, while still benefiting from corporation status. However, S-corps are limited to a maximum amount of 100 shareholders.
Legal Forms of Business Incorporation
This article has outlined different ways of legal organization from the simplest and smallest to the largest and most complex. Individuals and investors considering the creation of a new business or company should evaluate each option in order to make an educated decision about which one serves them best.