The legal structure of a home business is largely dependent upon factors including personal preference, taxes, personal liability, business goals, individual situation and type of business. Before you make a decision about what type of business to start, it is prudent that you consider the pros and cons of the legal structure pertaining to that business to determine which structure is best for your business.
The easiest home business structure is sole proprietorship because it is much more flexible than a corporation or an LLC. In a sole proprietorship you are the business owner and are personally liable for whatever debts you incur. Corporate structures, while providing more protection for the individual, are much more complex to form and quite rigid. It is critical to seek professional guidance from a tax consultant and/or a lawyer as you focus on your business’ legal issues. There are three basic business structures:
- Sole proprietorship
1. Sole Proprietorship
The sole proprietorship is the most popular form of legal home business structures. As the name implies, its ownership is completely vested in one person and has no necessary legal formalities. The only requirement is a local business license.
- It is quick, easy and inexpensive to establish.
- You have total ownership and control.
- All the profits belong to you.
- There is no federal taxation (on business profits).
- Income tax filing for the business is a part of your annual personal tax returns.
- You are personally liable for all business debts.
- It tends to be more difficult to borrow money or obtain outside investment.
- If anything happens to you, your business is likely to fail because all management responsibility is with you.
A partnership is divided between two or more people. There are two kinds of partnerships, limited and general. General partnerships are more common, with all partners sharing the profits and the liabilities. In a limited partnership, there is limited liability for the partners meaning that the liability can be no greater than the partner’s investment. In a limited partnership there must be a least one general partner who remains liable for all the debts of the business. Forming a partnership is complex and legal advice is very important, as the kind of partnership you form will determine your potential for liability.
- A thriving business environment as a result of partners who have different areas of expertise.
- A partnership does not pay federal income taxes.
- Liability is spread out.
- Investments and loans are more readily available.
- The formation of a partnership, and any subsequent changes, are complex.
- Problems with a partner can result in misunderstandings and mistrust – different goals that can weaken or destroy the partnership.
- General partners have unlimited liability, which means that you may be liable for the commitments of your partners.
There are three major types of corporations, a regular corporation or C-Corporation, an S-Corporation, and a Limited Liability Corporation (LLC). Each form is a complex legal entity, with detailed structures that vary state to state. It is essential to obtain legal advice if you are considering forming a corporation for your home business. Many people think that by incorporating their home business they minimize their personal liability, but there is no such thing as total insulation from losses. Record keeping and tax issues with a corporation are difficult, time-consuming and require the services of a professional.
A corporation is a taxable entity and is required by law to pay taxes. This results in “double taxation”, where a corporation pays corporate taxes on its profits, and the shareholder pays personal taxes on the dividends the corporation pays. Incorporating your business does make it easier to establish credit and borrow money.
- Shareholders enjoy limited personal liability.
- It is easier to obtain investment capital.
- Profits may be divided among owners and the corporation in order to reduce taxes.
- A corporation is not dissolved upon the death of a stockholder or if ownership changes.
- It is more expensive and complex to set up.
- Filing tax returns usually requires the help of an accountant.
- Double taxation is charged on profits paid to owners.
- Recurring annual corporate fees.
An S-corporation offers the limited liability advantages of a corporation, but does not pay federal taxes. However, all earnings and losses of an S-corporation are passed through to the shareholders. Though a popular form of incorporation, it is complex to set up and has multiple legal issues.
- Owners enjoy limited personal liability.
- There is no federal income tax.
- There is no double taxation involved.
- An S-corporation does not dissolve if an owner dies or leaves.
- Legal assistance is required to set up an S-Corporation.
- There is a maximum of 75 shareholders.
- Only one class of common stock is permitted.
3. Limited Liability Corporation (LLC)
LLCs are becoming a popular type of incorporation because it combines the tax advantages of a partnership with the limited liability advantages of a corporation without having to pay federal taxes. Its main disadvantage though, is that if a stockholder dies or leaves, the LLC is dissolved.
- Limited personal liability for the owners.
- No federal taxes.
- No limit on the number of stockholders.
- More than one class of stock is permitted.
- Legal assistance is required for complex paperwork.
- The LLC dissolves if one of the stockholders dies or leaves.
- Some states require that an LLC have more than one member.