Once you’ve decided to start your microbusiness, you will need to consider what to do to make it legal, taking into account how to protect yourself and how to get the best tax situation. Your choices are to be a corporation, partnership or sole proprietorship. The most common for a microbusiness is sole proprietorship, so lets start with that. You can always change your legal structure later if you need to.
Sole Proprietorship
The sole proprietorship is the simplest type of business to form and to maintain. You don’t need to complete any paperwork beyond getting a license to do business from your local city or county. You are the owner and you keep complete control of and responsibility for your business. You get all the profits and all the losses. You are responsible for all obligations of the business. As the sole proprietor you make all the decisions about your business. You don’t have to deal with partners or shareholders.
A benefit of being a sole proprietor is that there is no double taxation, no additional tax on business profits. You record your profits and losses on the Schedule C of your personal tax return. Even though you and the business are essentially the same, you should keep your business records and personal records separate and have a separate account for your business expenses and incomes. You’ll be glad you did come tax season.
The disadvantages of having a sole proprietorship are that it is harder to borrow money or obtain outside investment than with other types of legal structures, you have no liability protection – your personal assets are at risk through your business, and the health of the business depends to a large degree on the health of the owner.
Partnership
There are two basic types of partnerships: general and limited partnerships. Here people share ownership of a company without the hassles of incorporating. A big benefit from this is that partners can have different skills and can share duties and responsibilities.
From the tax standpoint, partnerships do not have to pay federal income tax. Profits and losses are passed through to the partners themselves and are usually treated as personal income. You’ll need to draw up some paperwork to define the partnership, but it is not as complicated as is needed for a corporation.
One thing to be aware of is that problems and disagreements among partners can kill the business if not resolved and you’ll have to decide what happens if one partner wants to leave.
For General Partnerships the partners manage the company and assume responsibility for each others debts and obligations. Profits and losses are allocated to the partners as they see fit. Also be aware that each general partner is fully responsible for all of the liabilities of a business.
Limited Partnerships have general partners who run the business and silent partners who are strictly investors. The silent partners don’t have active control and aren’t subject to the liabilities that the general partners are subject to.
Corporations
There are four types of corporations: C, S, LLC and nonprofits. It is more complicated and expensive to set up and run a corporation than a sole proprietorship or partnership. You’ll want a lawyer to draw up paperwork, which must be submitted to the state. Corporations are legal entities that have their own rights, privileges, and liabilities apart from the individuals who form them.
There are some good reasons individuals and microbusinesses would want to form corporations.
- The shareholders (the owners) of a corporation are generally not personally responsible for the debts or obligations of the corporation.
- Stockholders’ personal liability is usually limited to what they have invested in the corporation.
- A corporation continues to exist even if one of the shareholders dies or leaves the corporation which means none of the squabbles or wries about continuity that come with the other company structures.
- Corporations find it easier to raise money.
There are some disadvantages to incorporation as well. In addition to the cost and complexity of being a corporation, C corporations have the problem of double taxation. The corporation pays corporate taxes on its profits, and then, you as the owner/shareholder also have to pay personal taxes on the dividends you get from the corporation.
S corporations are more attractive to microbusinesses because they offer some extra tax advantages. They are simpler to form than C corporations and they are not subject to double taxation. Profits and losses from an S corporation get passed through to the owners.
Limited Liability Corporations are a basically a combination of partnerships and corporations. Their main features are:
- They have the pass through tax advantages of a partnership.
- They have the limited liability advantages of a corporation.
- They are easier to form than a corporation and require less paperwork and cost to keep going.
- They don’t last forever: they are dissolved when a member leaves, dies.
A nonprofit is a special type of corporation. All the profit that it produces must stay in the corporation–it is not passed on. You would make money by being an employee and receiving a “fair” wage for your work. There are a lot of restrictions on setting up and running a nonprofit that make them complicated to run. You can’t just say you are going to be a nonprofit. You have to meet certain requirements. It is a good choice if you are more interested in doing something for the public good then in maximizing your profits.
Final Word
This has been a simple overview of what can be a complex topic. While most microbusinesses are going to be sole proprietorships, you should at least consider other types of business structures with the different tax and liability aspects of each. It doesn’t hurt to plan ahead. If you have any doubts, get some professional help. The money you spend now is a good investment in the future of your business.
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