Whether it’s the desire to be your own boss or to have a shorter commute, many people decide to start their own businesses. When doing so, one of the first things to do is choose a business entity. However, before doing so, it is important to understand the benefits of drawbacks of each entity.
Sole proprietorship
Sole proprietorships are the simplest and least expensive form of business. All that is required to form the proprietorship is to obtain any state and local business licenses that are needed and to file a trade name registration.
A benefit of this form of business is that it does not pay business taxes like other forms of businesses. All income (or losses) generated by the business are reported on the proprietors individual income tax return. The proprietor is not required to withhold income or payroll taxes on his or her income from the business unless the business has employees. Additionally, this form of business requires proprietors to be diligent about putting aside a portion of profits to pay state and federal income taxes.
The main disadvantage of this type of entity is that the law views the proprietor and business as one, so the proprietor is personally liable for all debts and obligations of the business.
Partnerships
Partnerships are also quite easy to form. In New Jersey, when two persons associate to carry on as co-owners of a business for profit, a partnership is formed. There are many forms of partnerships such as general partnerships, limited partnerships and limited liability partnerships. Each type has its own formation requirements, rules concerning partner involvement in the operation of the business and level of protection against personal liability for the debts and obligations of the business.
Like sole proprietorships, partnerships generally do not pay business taxes. The partners pay taxes on the partnership’s income through their personal income taxes.
Limited liability companies
A limited liability company (LLC) has both partnership and corporation characteristics. There are more formational and operational formalities than partnerships or proprietorships. Each LLC is formed by filing a certificate of formation and filing fee. Additionally, LLCs must file an annual report.
Unlike partnerships, LLCs shield its members and managers from personal liability for the business’ debts. However, like partnerships, LLCs enjoy pass-through taxation where the business itself does not pay taxes; the owners pay taxes on their income tax returns.
Corporations
Corporations are significantly more complex to set up, but offer certain benefits. A corporation is formed by filing a certificate of incorporation after which the corporation’s board of directors must hold an organizational meeting to issue stock, adopt by-laws and elect officers. In addition, certain formalities such as keeping detailed business records must be followed to retain the company’s standing as a corporation.
As long as the corporate formalities are followed, the business is its own legal entity apart from its owners. As such, owners (or shareholders) are not personally responsible for any debts, liabilities or obligations of the business.
In addition, taxation of the business is different, depending on whether the company elects to be taxed as a C Corporation or S Corporation. C Corporations pay business taxes on profits directly from the business assets. In general, S Corporations divide the profits among its shareholders, who must include the taxes on their personal income tax returns.
Consult an attorney
The choice of a business entity is one of the vital first choices to make when starting a business. As this is just a basic summary of the different forms, it is important to seek the advice of an experienced business attorney who can recommend an entity based on your situation.