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Business Entity Basics
Before even the most promising business can put down roots and prosper, its owners must make the threshold decision about what kind of legal entity it will be. Different options are available, with each option having strengths and weaknesses. Legal requirements may vary by state depending on the business form chosen. Following are some general characteristics of the most prominent business entities. As the variety of choices indicates, competent legal advice is necessary to make proper decision.
Sole Proprietorship
The greatest virtue of a sole proprietorship is its simplicity. From a legal standpoint, the business and its owner are the same. This allows the proprietor to avoid most of the formalities required for some other business forms. For example, business income is reported on the proprietor's personal tax return. One significant drawback is the sole proprietor has personal responsibility for all business debts and court judgments.
General Partnership
A partner is a business run by two or more persons, but the "persons" can be individuals or business entities. In a general partnership, all partners are "general partners," which essentially means that their business fates are closely intertwined. Each general partner has unlimited personal liability for partnership debts, can incur obligations on behalf of the partnership, and acts as an agent for other partners and the partnership. The partners usually share equally in managing the business and dividing the profits, but they may set their own terms for these and other matters in a written partnership agreement. Tax liability on partnership income is "passed through" to the individual partners so that each partner pays taxes on his or her individual share of the profits.
Limited Partnership
In limited partnership, there are general partners and limited partners. General partners run the business's day-to-day operations and have personal liability for partnership obligations. Limited partners are usually passive investors in the business. They are not personally liable for partnership debts and the most they can lose is the amount invested in the partnership. A limited partnership allows money to be raised for the business from the limited partners, but the general partners do not have to share with them day-to-day decision making or comply with requirements for creating a corporation and issuing stock. In contrast with a corporation, a partnership dissolves and is liquidated upon the death or withdrawal of a partner unless the partnership agreement provides otherwise. For example, the agreement may allow a buyout of a deceased or withdrawn partner, election of a new partner, and continuation of the business. As a general rule, a limited partnership carries on unaffected by loss of a limited partner.
Corporation
A corporation is an entity that is separate from its owners, with its own legal rights and responsibilities. The owners (the corporation's shareholders) are not personally liable for debts of the corporation. The shareholders elect a board of directors to supervise the corporation and the board hires officers to manage day-to-day matters. The major drawback for the corporate model is having its income taxed twice: first on the corporation's income and then on dividends paid to the individual shareholders. The S corporation, a hybrid creature of the Tax Code, has some characteristics of corporations and some of partnerships. If specific tax rules are satisfied, income is an S corporation is taxed only when it is passed through the owners. Also, the owners retain their insulation from personal liability for corporate debts.
Limited Liability Company
An increasingly popular form of business entity is the limit liability company (LLC), another hybrid combining some of the best traits of the other entitles. The owners, called members, are not limited in number or type, as are shareholders in an S corporation. While LLC members generally have the kind of limited personal liability associated with limited partners, they have flexibility to participate in the management of the business if the governing document, called "articles of organization", so provides. The earnings of an LLC are given the same advantageous passed-through treatment, as are earnings of a sole proprietorship or partnership, thereby avoiding double taxation.
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