Introduction
When someone starts a business, the type of business they choose affects many things. This includes how they report their income or losses to the tax office, the amount of taxes they pay, how much money the business can hold onto, and how much of their own money is at risk if the business doesn’t do well. There are five main types of businesses: sole proprietorships, partnerships, limited liability companies (LLCs), S corporations, and corporations. Understanding the kind of business a self-employed borrower has helps lenders figure out if the business is doing well and how involved the borrower is in it.
Overview
Businesses are set up in different ways, which affects everything from taxes to how much of their own money owners might have to use to cover business debts. The five main types of businesses are sole proprietorships, partnerships, LLCs, S corporations, and corporations. Knowing what type of business a borrower has helps lenders understand the business’s health and the borrower’s role in it.
Sole Proprietorships
A sole proprietorship is a business owned and run by one person. This person has to pay for any business debts out of their own pocket. If the business doesn’t make money, the owner has to find new income and still pay off business debts. The owner’s personal and business assets are considered the same, meaning creditors can take personal assets (like a house) to pay business debts. The success of the business heavily relies on the owner’s ability to manage and fund it. If the owner dies, the business ends, and assets might be tied up in legal processes, delaying payment to people the business owes money to and the owner’s family.
Business income and expenses are reported on the owner’s personal tax return, and profits are taxed as personal income. Lenders looking at a sole proprietor need to make sure the business makes enough money to cover the business needs and the mortgage payments. They also check if the business can handle the owner taking money out for personal use without hurting the business.
Partnerships
Partnerships involve two or more people who agree to share the profits and losses of a business. There are general and limited partnerships. In a general partnership, each partner is fully involved in running the business and is personally responsible for business debts. If a partner leaves or passes away, the partnership has to end, but creditors can still go after former partners for debts. In a limited partnership, some partners invest money but don’t help run the business. They only risk the money they put in and usually can’t make big decisions. At least one partner must be fully involved and responsible for all debts. If a limited partner leaves or passes away, the partnership doesn’t have to end.
Partnerships don’t pay taxes directly. Instead, profits and losses are reported on a special form, and each partner reports their share on their personal tax return, paying taxes at their personal rate. Lenders need to check if a borrower has guaranteed any partnership debts, if they have received money from the partnership, and their share of any expenses that didn’t involve actual money but can still count as business costs.
Limited Liability Companies
An LLC is a mix of a partnership and a corporation, offering owners tax benefits and protection from personal liability in many situations. Owners can manage the business directly or appoint managers. Sometimes, owners might still have to personally guarantee loans. Profits can be shared with people outside the owner group, like managers.
LLCs report income and losses like partnerships or S corporations, but don’t pay taxes themselves. Owners report their share of profits or losses on their tax return and pay taxes at their personal rate. Lenders need to check if the borrower actually got money from the LLC and if they have guaranteed any LLC debts.
S Corporations
An S corporation doesn’t pay taxes on its earnings. Instead, profits and losses go to the shareholders, who report them on their personal tax returns and pay personal income tax. This setup is similar to a partnership. An S corporation, however, lets owners avoid double taxation on dividends, combining the benefits of a corporation and a partnership.
Lenders need to see if a borrower got cash from the S corporation and review the corporation’s overall cash flow, treating it much like any other business when evaluating its financial health.
Corporations
Corporations are independent legal entities separate from their owners, offering the most flexibility to raise money and protect owners from personal liability beyond their stock investment. Corporations can be public (with shares traded openly) or private (where a few people own most of the shares). Public corporations can raise funds from the general public, while private ones cannot.
Owners don’t run the business directly but elect a board of directors to make decisions. Profits can be shared as dividends, but owners aren’t personally liable for corporate debts beyond their investment. Corporations pay taxes on profits, and shareholders pay taxes on dividends received.
References
For more details, visit Business Structures of the Fannie Mae Selling Guide.