When you are starting a home-based business, you have a lot of things to consider. One major consideration is what form your business will take. Will you go with a “sole proprietorship?” How about an LLC or corporation? How do you know what to choose?
Well, before we begin, allow me to state that I am not a lawyer and this article is not intended to render legal or financial advice. It is for information purposes only and you are strongly cautioned to seek out advice from competent professionals before starting your business.
As you can tell by the copyright notice on every page of this site, my wife and I selected a Limited Liability Company as our chosen business structure. In this article, I would like to share a few reasons why. Let’s start by taking a look at some of the more common structures.
Sole Proprietorship – Originally, our business was a sole proprietorship. Yes, even though there are two of us, we could be counted as one owner since Arizona is a community property state and we file our taxes jointly. Sole proprietorship companies are, by far, the easiest to form. Basically, the owner is the company. There is no legal distinction between the two.
Income is reported on the owner’s income tax form so there is no need to file a separate return for the business. In fact, I’m not sure that doing so would even be allowed.
The major downside is that the owner is personally liable for all of the obligations of the business. In short, if the business loses a lawsuit, the business owner could lose everything. That didn’t appeal to us much.
Partnership – We didn’t even consider this option because, being married and in a community property state, it’s kind of a moot point. Partnerships are usually formed by two or more people who are not married to each other. The formation of a partnership usually requires a formal legal agreement detailing how the business will be managed, how profits will be divided and what happens to any assets should the business cease to exist. As far as US federal income taxes are concerned, profits and loses are passed through the business proportionately to each individual partner. Each partner would then include the business proceeds (or loses) on their individual income tax return.
In most states, partners in a general partnership still have unlimited personal liability, meaning each partner is personally liable for all obligations of the business.
Corporation – Now we’re getting into the structures which offer liability protection. Corporations are separate legal entities. This means that the corporation is liable for its own obligations and the owners typically only risk the amount of their investment in the business.
There are two basic types of for profit corporations. They are commonly called “C corporations” and “S corporations.”
“C corporations” are what you normally hear about with large companies. They file their own income tax returns, can be publicly traded with thousands of stockholders and issue multiple classes of stock. S corporations, on the other hand, can only have 100 stockholders (who must be US citizens/residents). S corporations cannot be owned by a C corporation or another S corporation.
Unlike C corporations, which file their own tax return, S corporations pass their profits and losses through to the stockholders, who include this on their personal returns.
Both types of corporations have similar legal requirements, such as drafting of bylaws, annual meetings, etc. It was these legal requirements, combined with the higher cost of organization that caused us to skip this structure.
Limited Liability Company – Now, we reach the structure that we chose. Be warned that LLCs are still a fairly new business structure so laws tend to differ from state-to-state.
LLCs offer liability protection similar to a corporation, but without all of the headaches. In most states, an LLC may be owned by a single person.
The owners of an LLC are called “members.” In most states, you must decide if the LLC will be managed by the members or if one of the members will be the designated “manager.”
When setting up an LLC, you have to decide how the business will handle taxes. If a single-owner LLC, you have the option of being taxed as a sole proprietor. This means that all profits and losses will be reflected on your personal return.
If the LLC is owned by two or more people, they can choose to be taxed as a partnership or as a corporation.
In community property states, like Arizona (are you sick of hearing this yet?), married couples can own an LLC together and have it be treated almost like a sole proprietorship. The IRS refers to this as a “disregarded entity.”
We chose the LLC route because it offered the liability protection we were after along with ease of tax filing and the cost to form was a lot lower. I believe it cost us $100 to form our LLC here. It was $50 for the filing and $50 to publish the articles of organization in the newspaper. Costs do vary from state to state. I just heard that California charges $800 per year for an LLC. That just blows my mind.
Keep in mind that you don’t have to form a corporation or LLC in the state in which you reside. Many people choose other states, such as Delaware or Nevada for their favorable tax breaks. If you do form your business in another state, you are likely to need a resident agent in that state. This is simply a person who receives legal documents and acts as a local presence for the company
I hope this little article has helped you. Like I said, I am not an attorney or CPA and this is not intended to give professional advice. I’m just sharing what I picked up while forming our company a few years ago.
Which option appeals most to you? Why? Be sure to let me know by leaving a comment.
Likewise, if you notice a mistake in the article, please correct me as well.
PS: No matter which structure you choose, it can be tricky to get all of the paperwork right. I seriously caution you NOT to go it alone. If you do not have a lawyer, I suggest you use a service like Legal Zoom
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Choosing the right business structure is critical. As I see it, going for an LLC structure is more flexible. The management style and the compliance requirements are way less formal and complicated compared to a corporation.