Before you can decide how you want to structure your business, you’ll need to know what your options are. Here’s a brief rundown on the most common ways to organize a business:
- sole proprietorship
- limited partnership
- limited liability company (LLC)
- corporation (for-profit)
- nonprofit corporation (not-for-profit), and
Sole Proprietorships and Partnerships
For many new businesses, the best initial ownership structure is either a sole proprietorship or — if more than one owner is involved — a partnership.
A sole proprietorship is a one-person business that is not registered with the state like a limited liability company (LLC) or corporation. You don’t have to do anything special or file any papers to set up a sole proprietorship — you create one just by going into business for yourself.
Legally, a sole proprietorship is inseparable from its owner — the business and the owner are one and the same. This means the owner of the business reports business income and losses on his or her personal tax return and is personally liable for any business-related obligations, such as debts or court judgments.
Similarly, a partnership is simply a business owned by two or more people that hasn’t filed papers to become a corporation or a limited liability company (LLC). You don’t have to file any paperwork to form a partnership — the arrangement begins as soon as you start a business with another person. As in a sole proprietorship, the partnership’s owners pay taxes on their shares of the business income on their personal tax returns and they are each personally liable for the entire amount of any business debts and claims.
Sole proprietorships and partnerships make sense in a business where personal liability isn’t a big worry — for example, a small service business in which you are unlikely to be sued and for which you won’t be borrowing much money for inventory or other costs. To learn more about starting and running a sole proprietorship or partnership, read Nolo’s articles on each topic.
Limited partnerships are costly and complicated to set up and run, and are not recommended for the average small business owner. Limited partnerships are usually created by one person or company (the “general partner”), who will solicit investments from others (the “limited partners”).
The general partner controls the limited partnership’s day-to-day operations and is personally liable for business debts (unless the general partner is a corporation or an LLC). Limited partners have minimal control over daily business decisions or operations and, in return, they are not personally liable for business debts or claims. Consult a limited partnership expert if you’re interested in creating this type of business.
Corporations and LLCs
Forming and operating an LLC or a corporation is a bit more complicated and costly, but well worth the trouble for some small businesses. The main benefit of an LLC or a corporation is that these structures limit the owners’ personal liability for business debts and court judgments against the business.
What sets the corporation apart from all other types of businesses is that a corporation is an independent legal and tax entity, separate from the people who own, control and manage it. Because of this separate status, the owners of a corporation don’t use their personal tax returns to pay tax on corporate profits — the corporation itself pays these taxes. Owners pay personal income tax only on money they draw from the corporation in the form of salaries, bonuses, and the like.
Like corporations, LLCs provide limited personal liability for business debts and claims. But when it comes to taxes, LLCs are more like partnerships: the owners of an LLC pay taxes on their shares of the business income on their personal tax returns.
Corporations and LLCs make sense for business owners who either (1) run a risk of being sued by customers or of piling up a lot of business debts, or (2) have substantial personal assets they want to protect from business creditors. To learn more about forming an LLC or a corporation, see Nolo’s articles on each topic.
A nonprofit corporation is a corporation formed to carry out a charitable, educational, religious, literary, or scientific purpose. A nonprofit can raise much-needed funds by soliciting public and private grant money and donations from individuals and companies. The federal and state governments do not generally tax nonprofit corporations on money they take in that is related to their nonprofit purpose, because of the benefits they contribute to society. To learn more about nonprofit corporations, seeNonprofit Basics.
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Some people dream of forming a business of true equals — an organization owned and operated democratically by its members. These grassroots business organizers often refer to their businesses as a “group,” “collective,” or “co-op” — but these are often informal rather than legal labels. For example, a consumer co-op could be formed to run a food store, a bookstore, or any other retail business. Or a workers’ co-op could be created to manufacture and sell arts and crafts. Most states do have specific laws dealing with the set-up of cooperatives, and in some states you can file paperwork with the secretary of state’s office to have your cooperative formally recognized by the state. Check with your secretary of state’s office for more information.
For more online guidance on deciding which ownership structure is most suitable for your business, see Choosing the Best Ownership Structure for Your Business.
You may want to also read LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso (Nolo).
Most people have heard that forming a corporation provides “limited liability” — that is, it limits your personal liability for business debts. What you may not know is that there’s more to creating and running a corporation than filing a few papers. You’ll need to keep good records to handle the more complicated corporate tax return and, in order to retain your limited liability, you must follow corporate formalities involving decision making and record keeping. In short, you’ve got to be organized.
Limited Personal Liability
One of the main advantages of incorporating is that the owners’ personal assets are protected from creditors of the corporation. For instance, if a court judgment is entered against your corporation saying that it owes a creditor $100,000, you can’t be forced to use personal assets, such as your house, to pay the debt. Because only corporate assets need be used to pay business debts, you stand to lose only the money that you’ve invested in the corporation.
Exceptions to Limited Liability
There are some circumstances in which limited liability will not protect an owner’s personal assets. An owner of a corporation can be held personally liable if he or she:
- personally and directly injures someone
- personally guarantees a bank loan or a business debt on which the corporation defaults
- fails to deposit taxes withheld from employees’ wages
- does something intentionally fraudulent or illegal that causes harm to the company or to someone else, or
- treats the corporation as an extension of his or her personal affairs, rather than as a separate legal entity.
This last exception is the most important. In some circumstances, courts can rule that a corporation doesn’t really exist and that its owners should not be shielded from personal liability for their acts. This might happen if you fail to follow routine corporate formalities such as:
- adequately investing money in (“capitalizing”) the corporation
- formally issuing stock to the initial shareholders
- regularly holding meetings of directors and shareholders, or
- keeping business records and transactions separate from those of the owners.
Incorporating should never take the place of good business insurance. Even though forming a corporation protects your personal assets, you should use insurance to guard your corporate assets from lawsuits and claims.
A solid liability insurance policy can protect you against many of the risks of doing business. For instance, if you operate a clothing store, good business insurance should adequately cover the bill if someone slips and falls in your store.
Also, insurance can protect you where the limited liability feature will not. For example, if you personally injure someone while doing business for the corporation, say by causing a car accident, liability insurance will usually cover the accident so that you won’t have to use either corporate or personal assets to pay the bill. However, insurance won’t help if your corporation doesn’t pay the bills: commercial insurance usually does not protect personal or corporate assets from unpaid business debts, whether or not they’re personally guaranteed.
Paying Corporate Income Tax
If an owner of a corporation works for the corporation, that owner is paid a salary, and possibly bonuses, like any other employee. The owner pays taxes on this income just like regular employees, reporting and paying the tax on his or her personal tax return.
The corporation pays taxes on whatever profits are left in the businesses after paying out all salaries, bonuses, overhead, and other expenses. To do this, the corporation files its own tax return, Form 1120, with the IRS and pays taxes at a special corporate tax rate.
Alternatively, corporate shareholders can elect what’s called “S corporation” status by filing Form 2553 with the IRS. This means that the corporation will be treated like a partnership (or LLC) for tax purposes, with business profits and losses “passing through” the corporation to be reported on the owners’ individual tax returns. To learn more about S corporations, see Nolo’s article S Corporation Facts.
For more details on regular corporate taxation, see Nolo’s article How Corporations Are Taxed.
Forming a Corporation
To form a corporation, you must file “articles of incorporation” with the corporations division (usually part of the secretary of state’s office) of your state government. Filing fees are typically $100 or so.
For most small corporations, articles of incorporation are relatively short and easy to prepare. Most states provide a simple form for you to fill out, which usually asks for little more than the name of your corporation, its address, and the contact information for one person involved with the corporation (often called a “registered agent”). Some states also require you to list the names of the directors of your corporation.
In addition to filing articles of incorporation, you must create “corporate bylaws.” While bylaws do not have to be filed with the state, they are important because they set out the basic rules that govern the ongoing formalities and decisions of corporate life, such as how and when to hold regular and special meetings of directors and shareholders and the number of votes that are necessary to approve corporate decisions.
Finally, you must issue stock certificates to the initial owners (shareholders) of the corporation and record who owns the ownership interests (shares or stock) in the business.
To learn more about how to form your corporation, see Nolo’s article How to Form a Corporation.
Retaining Corporate Status
Corporations and their owners must observe certain formalities to retain the corporation’s status as a separate entity. Specifically, corporations must:
- hold annual shareholders’ and directors’ meetings
- keep minutes of shareholders’ and directors’ major decisions
- make sure that corporate officers and directors sign documents in the name of the corporation
- maintain separate bank accounts from their owners
- keep detailed financial records, and
- file a separate corporate income tax return.
For more information on making corporate decisions and keeping corporate minutes, see Nolo’s article Documenting Corporate Decisions.
The Internet is one of the most fertile grounds on which you can build a business to sell your products or services. This is because of the fact that your customer base is potentially in the order of millions of prospective buyers who are not restricted by physical location.
eCommerce (also known as ‘electronic commerce’) refers to business conducted online. At one time, the term included only web businesses such as Amazon and Travelocity that transferred a real world paradigm – buying books or booking flights — to the Internet. But heading into the second decade of the 21st Century, practically all business is conducted online in some way and eCommerce includes a wide range of subject matter, whether it’s downloading an app, clicking on an adword at a blog, licensing content from iStockphoto, or purchasing a legal form. In fact it’s hard to imagine a business without some eCommerce aspect.
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Nolo has books, forms, and online applications that can help small business owners run a successful business. See the Small Business Products page for a complete list of Nolo’s small business products,
Whether you’re buying a franchise, creating a start-up, purchasing an existing operation or turning a hobby into a home-based entity – starting a business of any kind involves a great deal of planning and preparation. In addition to helping you incorporate or form an LLC, as well as providing information about how to start a business in each particular state,
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