Sorting Out Business Legal Structures
Business type and tax preparation and reporting go hand in hand. If you work as a bookkeeper for a small business, you need to know the business’s legal structure before you can proceed with reporting and paying income taxes on the business income. Not all businesses have the same legal structure, so they don’t all pay income taxes on the profits they make in the same way.
But before you get into the subject of tax procedures, you need to understand the various business structures you may encounter as a bookkeeper. This article outlines each type of business. You can find out how these structures pay taxes in separate sections that follow.
The simplest legal structure for a business is the sole proprietorship, a business that’s owned by one individual. (If a business has only one owner, the IRS automatically considers it a sole proprietorship.)
Most new business with only one owner start out as sole proprietorships. Some never change their statuses, but others grow by adding partners and becoming partnerships. Some add lots of staff and want to protect themselves from lawsuits, so they become Limited Liability Companies (LLCs). Those seeking the greatest protection from individual lawsuits, whether they have employees or are simply single-owner companies without employees, become corporations.
The IRS considers any business owned by more than one person a partnership. The partnership is the most flexible type of business structure involving more than one owner. Each partner in the business is equally liable for the activities of the business. This structure is slightly more complicated than a sole proprietorship and partners should work out certain key issues before the business opens its doors. These issues include
- How the partners will divide the profits
- How each partner can sell his or her share of the business, if he or she so chooses
- What will happen to each partner’s share if a partner becomes sick or dies
- How the partnership will be dissolved if one of the partners wants out
Partners in a partnership don’t always have to share equal risks. A partnership may have two different types of partners: general and limited. The general partner runs the day-to-day business and is held personally responsible for all activities of the business, no matter how much he or she has personally invested in the business. Limited partners, on the other hand, are passive owners of the business and not involved in its day-to-day operations. If a claim is filed against the business, the limited partners can only be held personally liable for the amount of money that matches how much they individually invested in the business.
Limited Liability Companies (LLCs)
The Limited Liability Company, or LLC, is a structure that provides partnerships and sole proprietorships with some protection from being held personally liable for their businesses’ activities. This business structure is somewhere between a sole proprietorship or partnership and a corporation: The business ownership and IRS tax rules are similar to those of a sole proprietorship or partnership, but like a corporation, if the business is sued, the owners aren’t held personally liable.
LLCs are state entities, so the level of legal protection given to a company’s owners depends upon the rules of the state in which the LLC was formed. Most states give LLC owners the same protection from lawsuits as the federal government gives corporation owners. However, these LLC protections haven’t been tested in court to date, so no one knows for certain whether or not they hold up in the courtroom.
If your business faces a great risk of being sued, the safest business structure for you is the corporation. Courts in the United States have clearly determined that a corporation is a separate legal entity and that its owners’ personal assets are protected from claims against the corporation. Essentially, an owner or shareholder in a corporation can’t be sued or face collections because of actions taken by the corporation. This veil of protection is the reason many small business owners choose to incorporate even though it involves a lot of expense (both for lawyers and accountants) and government paperwork.
In a corporation, each share of stock represents a portion of ownership, and profits must be split based on stock ownership. You don’t have to sell stock on the public stock markets in order to be a corporation, though. In fact, most corporations are private entities that sell their stock privately among friends and investors.
If you’re a small business owner who wants to incorporate, first you must form a board of directors. Boards can be made up of owners of the company as well as nonowners. You can even have your spouse and children on the board.