When starting a business, one of the most important decisions to be made is how best to legally organize the company. In Iowa, there are four different types of legal organizations, each having its own advantages and disadvantages:
1. Sole Proprietorship. Sole proprietorships are owned and operated by one individual – there is no legal distinction between the owner and the business. As a result, they are relatively inexpensive and easy to set up. In a sole proprietorship, the business does not file a tax return; the income (or loss) passes through the business and is reported on the owner’s personal tax return. Within a sole proprietorship, the owner is personally responsible for any liabilities that the business incurs. Sole proprietorships are also less conducive to investment opportunities due to the absolute control enjoyed by the owner.
2. Corporation. Corporations are the most complex legal organization. A corporation is a legal entity separate and independent from the people who own or run the corporation, namely shareholders. Within a corporation, corporate shareholders have limited responsibility for the debts of the business because the corporation itself is responsible for all liabilities the company incurs. This limited liability for shareholders creates an atmosphere conducive to attracting new investment. However, businesses must also go through a more rigorous and costly process to become a corporation. Furthermore, earnings are subject to taxation at the entity and individual levels upon distribution to shareholders.
3. General Partnership. General partnerships are associations between two or more people in business seeking a profit. These partnerships are usually fairly easy to create and maintain, but it is essential to create a partnership agreement. Partnership agreements formalize the rules for the distribution of profits/losses, ownership percentages, dissolution terms, management rights, etc. The absence of a partnership agreement can lead to management and oversight issues down the road. General partnerships are tax-reporting entities, not tax-paying entities. A partnership must file an annual information return (Form 1065) with the IRS to report income and losses from operations, but it does not pay federal income tax. Instead, profits and losses are passed through to the owners based on their profit-sharing percentages outlined in the partnership agreement. Each partner pays taxes on their share of the profit/loss. Partners within a general partnership typically have unlimited personal liability meaning that each partner is jointly liable for all business debt and liability.
4. Limited Liability Company (LLC). An LLC is a hybrid combination of corporations, sole proprietorships, and general partnerships. Owners of an LLC are called members; these members may include individuals, corporations, other LLCs, and foreign entities. There is no limit on the number of members an LLC can have. LLCs are usually considered “pass-through entities” for tax purposes, meaning business income passes through the business to LLC members who report their share of profits or losses on the individual income tax returns. This revenue is often subject to additional taxes at the state level. Furthermore, even if profits aren’t distributed, each member’s share of profit represents taxable income. Accordingly, LLCs are only required to file informational tax returns. As the name suggests, LLCs protect their members by providing limited liability. Limited liability shields LLC members from being personally liable for business debts and claims. In an LLC, liability for business debt will only extend beyond the company’s assets in cases of fraud or illegality.
In many scenarios, the most prudent way to organize a new business is as an LLC. This is because LLCs combine the ease of having a partnership with the legal protections offered to corporations.