Forms of business ownership in the US

One of the first decisions any founder makes is the legal form of the business. The form decides who owns it, who is responsible if it cannot pay its debts, how its profit is taxed, how easily it can raise money and how much paperwork it needs. There is no single best form: a part-time freelance designer, a family restaurant and a technology start-up seeking investors need different structures. This lesson compares the main forms, works through the tax and liability differences with numbers, and ends with a way to choose.

The sole proprietorship

A sole proprietorship is a business owned by one person with no separate legal existence. The owner and the business are, in law, the same person. It is the simplest and cheapest form: you can start by simply doing business, though you may need to file a 'doing business as' (DBA) name with your county or state, obtain local licenses and register for state sales tax if you sell taxable goods. Profit is reported on Schedule C with the owner's Form 1040 and taxed at personal rates, and the owner also pays self-employment tax of 15.3 % (Social Security and Medicare) on most of the net earnings, up to the Social Security wage base for the year.

The big drawback is unlimited liability. If the business cannot pay a supplier, loses a lawsuit or defaults on a loan, creditors can go after the owner's personal savings, car and home. Insurance and careful contracts reduce the risk but do not remove it. A sole proprietorship also ends when the owner stops working or dies, and it can be hard to raise money because there are no shares to sell.

Partnerships

A partnership exists when two or more people carry on business together as co-owners for profit. It can arise without any paperwork, which surprises many friends who start a business together. In a general partnership, each partner is personally liable for all the partnership's debts, including debts created by another partner acting for the business. The partnership files an information return (Form 1065) but pays no federal income tax itself; profit flows through to the partners on Schedule K-1 and each pays tax on their share. States also allow limited partnerships, where limited partners invest money and are liable only up to that amount, and limited liability partnerships (LLPs), which protect partners from each other's malpractice and are popular with professional firms.

Every partnership should have a written partnership agreement covering how much each partner contributes, how profits and losses are shared, who makes which decisions, what happens if a partner wants to leave or dies, and how disputes are resolved. Without one, state partnership law fills the gaps, often with rules nobody intended, such as equal sharing of profit regardless of effort or capital.

Corporations

A corporation is a separate legal person, created by filing articles or a certificate of incorporation with a state, often the state where the business operates or Delaware, whose corporate law and specialized courts are popular with larger companies. It can own property, sign contracts, sue and be sued in its own name. Its owners are shareholders, who elect a board of directors, who in turn appoint officers to manage the business. Shareholders' liability is limited to what they invested, and a corporation continues to exist when shareholders change or die.

A regular corporation, called a C corporation, files Form 1120 and pays a flat 21 % federal corporate tax, plus state corporate tax in most states. When it pays dividends from after-tax profit, shareholders pay personal tax on them again, usually at qualified dividend rates of 0 %, 15 % or 20 %. This double taxation is the main drawback of a C corporation for a small business. Eligible small corporations can instead elect S corporation status by filing Form 2553. An S corporation pays no federal income tax itself; profit flows through to the shareholders. It is limited to 100 shareholders, who must be individuals (and certain trusts) who are US citizens or residents, and it can have only one class of stock.

Corporations cost more to set up and run. They must keep a minute book, hold or document annual shareholder and director meetings, file annual returns with the government, keep separate bank accounts and file a separate tax return. Limited liability is also not absolute. Lenders often demand personal guarantees from owners of small corporations, directors can be personally liable for unpaid employee wages and unremitted payroll and sales taxes, and courts can 'pierce the corporate veil' if owners treat the corporation as their personal piggy bank.

Limited liability companies

A limited liability company (LLC) is a state-law entity that combines the limited liability of a corporation with flexible management and pass-through taxation. Owners are called members. By default, a single-member LLC is disregarded for federal income tax, so its profit goes on the owner's Schedule C, and a multi-member LLC is taxed as a partnership. An LLC can instead elect to be taxed as a C corporation or an S corporation. LLCs are now the most popular form for new small businesses in the US because they are simpler than corporations, but members still pay self-employment tax on their share of profit unless the LLC elects S corporation treatment. Every LLC should have an operating agreement setting out ownership, management and what happens when a member leaves.

Comparing the forms

Franchises

A franchise is not a separate legal form but a business arrangement. The franchisor, such as a fast-food or hotel brand, licenses its name, systems and support to franchisees, who own and run individual locations, usually as corporations. In return, franchisees pay an initial fee and ongoing royalties, often 4 % to 8 % of sales, plus advertising fund contributions. Franchising lets owners start with a proven model and brand, at the cost of less independence and ongoing fees.

Franchising is regulated by the Federal Trade Commission's Franchise Rule, which requires franchisors to give prospective franchisees a Franchise Disclosure Document (FDD) at least 14 calendar days before they sign or pay, and by about a dozen states that require registration or impose relationship rules.

Choosing a form

A practical way to choose is to ask five questions. How much personal risk does the business carry, from lawsuits, debts and contracts? How much profit will it make, and how much will the owner leave in the business rather than spend? Will it need outside investors, and what form do they expect? How much administration can the owner handle? And what are the plans for the future, such as bringing in partners, selling the business or passing it to family? Many businesses start as sole proprietorships and change form as they grow.