One of the first things you need to do when starting a new business is deciding how it will be set up. Your decision will affect your tax status, will determine who has ownership in the business, and will delineate your personal liability if the business becomes heavily indebted or closes down in the future. In terms of business structure, there are basically three main categories: a sole proprietorship, a partnership, and a corporation.
Below is a brief rundown of each one:
A sole proprietorship is a business that is owned by a single individual. It is the easiest and cheapest structure to set up. But, it comes with some drawbacks. Under a sole proprietorship, the business owner assumes unlimited liability for all of the business's debts. The business' income or loss are also reported on the owner's personal income tax return.
With a partnership, there are multiple owners of a single business. Partnerships comes in two flavors: general and limited. A general partnership is like a sole proprietorship in that each co-owner assumes unlimited liability for the debts of the business. The business' income and expense is reported on a separate tax return, but co-owners must still report their personal share of the profit or loss from the business on their personal tax returns. With a limited partnership, each owner is limited in liability to his or her individual contribution to the business. Tax reporting is generally the same as that for a general partnership with a few exceptions.
A corporation is a separate legal entity that assumes responsibility for its own expenses and liabilities. This means that none of the shareholders in a corporation are held liable for the debts incurred by the corporation, and creditors are restricted to drawing from the corporation's assets when seeking repayment. The corporation also files its own tax return and pays taxes on its income, including the dividends that are distributed to its shareholders. Aside from these three business structures, there are two "hybrid" entities. The first is known as an "S" Corporation, which is treated as a partnership in terms of tax payments, yet is considered a regular corporation in other areas. The second entity which has become pretty popular among small businesses is known as a Limited Liability Company (LLC). This structure provides limited liability for all of its members, but is generally treated as a partnership for federal income tax purposes.
For more information regarding the various business structures and their respective tax obligations, check out the IRS Website [https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Business-Structures].