Starting, owning, and operating a business can be time consuming and very overwhelming. When deciding issues such as the nature and location of the business it is easy to overlook the issue of choosing a business entity. There are several of factors that must go into choosing a type of business entity and it is important to understand the consequences associated with each type. Consulting with both an attorney and a Certified Public Accountant will allow you to make an informed and knowledgeable decision. Often, the tax implications for the producer will be the guiding or determining factor in identifying and deciding upon a proper business entity.
There are many different business entity types from which to choose with each type having associated benefits and drawbacks. Types of business entities include sole proprietorships, partnerships, limited liability companies, and corporations. This section will discuss each of these business entities in greater detail. Each state has requirements in its statutes for setting up businesses and filing appropriate records to reflect those businesses. The producer should check with the proper state authorities, usually the Secretary of State, to determine the filing and recognition requirements for businesses in his or her state.
Sole proprietorship
The easiest type of business entity to start operating is a sole proprietorship. A sole proprietorship is a business entity owned and managed by one person. The sole proprietorship can be organized very informally and is not subject to federal or state regulations regarding its formation. A sole proprietorship is indistinguishable from the person owning and controlling the company. Because the sole proprietorship is indistinguishable from the person owning the company, the owner is personally liable for all actions of the company. A sole proprietorship is taxed at the individual income tax rate of the owner. A sole proprietorship does not pay income taxes separately from the owner. The benefit to operating a sole proprietorship is that there is no expense in creating and registering the business entity. In addition, there are no requirements regarding the management and control of a sole proprietorship. One drawback of a sole proprietorship is that it offers no liability protection to the owner. For example, if an owner of a sole proprietorship was sued as the result of an action that occurred while doing business as the sole proprietorship the owner could have money from a personal savings account garnished as a result of the lawsuit. Another drawback is that there are very few tax advantages for operating a sole proprietorship. The owner is subject to the federal self-employment tax which is often a substantially higher tax rate than that which other business entities are subjected.
Partnership
A partnership is created if two or more individuals agree to enter into a business arrangement. The agreement may either be in writing or may be oral. Though an oral partnership is legally enforceable it is always recommended that the partners define, in writing, the role that each individual performs and how the proceeds, assets, and debts of the partnership are distributed. Partnerships, like sole proprietorships, are generally not required to be registered with the state but in most states there are advantages for registering partnerships. A limited partnership is a type of partnership that requires registration with the state that limits the liability of the individual partners for actions taken by the partnership. Partnerships have the benefits of being relatively inexpensive to create and allowing individual partners to pool their resources and share control of the company. Drawbacks include personal liability, except in limited partnerships, and taxation at the individual income tax level.
Limited liability company
Limited liability companies, or LLC’s, are business entities which share characteristics of both partnerships and corporations. LLC’s limit the personal liability of members for obligations and/or actions of the company. LLC’s are created by filing Articles of Organization with the state in which they are to be created. There are fees associated with the filing of the Articles of Organization. Generally, the Secretary of State is charged with the registration of business entities within a state. In addition to the Articles of Organization, most states require that an operating agreement be drawn up that establishes the members of the company as well as how the company is controlled and the duties of the members. LLC’s are taxed in the same manner as sole proprietorships and partnerships. Profits and/or losses pass through the LLC and are taxed at the individual income tax level of each member. Since LLC’s have not been in existence as long as some of the other forms of business entities, the Courts have not fully explored the various protections afforded by these entities. Again, proper legal and accountant advice is necessary in determining the form of business entity.
Corporation
Corporations are the most complex type of business entity. A corporation is created by filing Articles of Incorporation, or a similar document depending on the state, with the designated agency within the state. Corporations are governed by bylaws that state the purpose and nature of the corporation, establish the rights of the shareholders, and name the directors and officers of the corporation. Corporations are owned by shareholders who own stock in the corporation. Corporations may be wholly owned by one person or may be traded publicly and owned by thousands of people. Many states have prohibitions against agricultural business being owned by corporations. Most states have exceptions to this rule where the corporation is owned by members of a family who are engaged in the operation of the farm. Corporations allow shareholders and officers to operate with limited liability for actions and/or obligations of the corporation. Corporations are generally taxed at both the corporate level and at the individual income tax level of the shareholders. Small corporations can often elect to be classified as an ‘S’ corporation. This means that taxes are not paid by the corporation and that the tax liability passes through the corporation and on to the shareholders.
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