If you've decided to start your own business, the next step is deciding what business formation method you will use. A fair number of options exist, each of which is detailed below.
A sole proprietorship is a business owned by one individual who is considered to be self-employed. A sole proprietor may still have employees working for him/her. A sole proprietor reports gains and losses on their own personal income tax form since a sole proprietorship is not legally considered a separate entity. The sole proprietor may be held personally responsible for the debts and liabilities of the business.
If more than one person own and carry on a business for profit, state statute declares that business a general partnership. It is the default entity. This means that even though two people own a business together and have not filed anything with the state and do not intend to form a "general partnership," legally they have. It does not matter that they did not intend to. Like a sole proprietorship, general partners report the gains and losses of the general partnership on their own personal income tax forms. The general partners may be held personally responsible for the debts and liabilities of the business.
A limited partnership is generally formed when there is one or more owners of the business that simply want to invest in the business and have no other part of it. The investor-owners become the limited partners and the other owners become general partners. The limited partners generally only have liability to the extent they have invested in the business. The general partners may be held personally responsible for the debts and liabilities of the business. Partners report gains and losses of the business on their own personal income tax forms.
Limited Liability Partnership
A limited liability partnership is, generally speaking, a general partnership except that ALL of the partners may enjoy limited liability, meaning that each may only be liable to the extent they have invested in the business. (Note: not all states recognize the LLP form).
Limited Liability Company
A limited liability company allows all members to enjoy limited liability. It also allows members to report gains and losses of the business on their personal income tax forms. One of the benefits also includes the fact that LLCs follow the statutory scheme of a C-corporation. This is beneficial because the statutes and case law of corporations in Minnesota, and other states, is very developed which allows lawyers to more easily predict how certain situations will be handled or viewed by a court of law.
A corporation is state law creation while the C simply signifies how the corporation is taxed for federal income tax purposes. C-corporations are taxed both at the entity level, on profits the business makes, and at the shareholder level, on distributions made to shareholders.
You might be surprised to learn that both corporation types (S and C corporations) are formed and operate the same in regards to state law purposes. The difference between the two corporation types lies in how they are treated for federal income tax purposes. A S-corporation pays no entity level tax allowing it to pass-through any gains and losses directly to its shareholders who report them on their personal income tax forms. In order to qualify for an S-corporation election, certain criteria need to be met. These qualifications limit the number of shareholders as well as who those shareholders may be.