How to Choose the Right Business Entity
Choosing the right business entity allows an entrepreneur to reduce liability exposure, minimize taxes, and ensure that the business can be financed and run efficiently. It also provides business owners with a mechanism for ensuring that the business operations will continue, rather than being automatically terminated, upon the death of an owner. Formalizing the business also clarifies the ownership of all participants in the venture.
When choosing a business entity, you should consider: (1) the degree to which your personal assets are at risk from liabilities arising from your business; (2) how to best pursue tax advantages and avoid multiple layers of taxation; (3) the ability to attract potential investors; (4) the ability to offer ownership interests to key employees; and (5) the costs of operating and maintaining the business entity.
Despite the implication in this article's title, you should not approach this subject with the idea that there is only one entity type that's right for your business. The choice you make will inevitably involve weighing the advantages and the disadvantages of several factors that apply to your particular business. You should also keep in mind that there will inevitably be various changes in the nature of your business over time, and these changes may make it more advantageous either to change your entity type or its tax classification. With that in mind, let's take a look at the main entity types that are available.
The availability of a particular entity type initially depends on the number of owners. A single owner may operate as a sole proprietor, a corporation, or a limited liability company. If there are two or more owners of the business, by definition it cannot be a sole proprietorship, but it can be a corporation, limited liability company, general partnership, limited partnership, or, in certain situations, a limited liability partnership.
We'll first review the entity choices available for a single business owner.
What is a Sole Proprietorship?
A sole proprietorship is a business owned by one person. It has no legal distinction from the owner, and usually requires no governmental filing other than a fictitious business name statement ("DBA") if the owner is doing business in any name other than a personal name. A sole proprietorship is probably the most common form of business because it is simple to start and avoids the operating expenses required for other legal entities such as corporations and limited liability companies.
No Personal Liability Protection
Because there is no legal distinction between the owner and the business, a sole proprietor is personally liable for all the debts and obligations of the business. It also means that on the death of the owner, the business enterprise terminates, leaving only the assets of the business such as equipment, accounts receivable, and real property. Because the assets used in the business are not separated from the other assets of the business owner, it may be difficult to sell the business as a whole after the death of the sole proprietor.
No Double Taxation Concern
For tax purposes, there is no distinction between the sole proprietor and the business. All income and expenses of the business are reported on the sole proprietor’s personal tax return. This means that the net income from the business is taxed only once.
Corporation Types: C Corporation, S Corporation, Nonprofit and More
A corporation is a separate entity from its owners for both legal and tax purposes. Corporations are formed by filing Articles of Incorporation with the Secretary of State. A corporation is comprised of three groups of people: shareholders, directors, and officers. The shareholders elect the board of directors who are responsible for setting major goals of the corporation and making major decisions. The board of directors appoints the officers, who run the business on a day-to-day basis.
Separate Entity Means Personal Liability Protection
Since a corporation is a separate legal entity, the corporation generally is responsible for the debts and obligations of the business. In most cases, shareholders are insulated from claims against the corporation.
Advantages of a Corporation
In addition to the limited liability protection enjoyed by shareholders, a corporation offers many other advantages over other types of entities:
- Ownership interests in the business are freely transferable:
the ready transferability of shares in the corporation facilitates estate planning;
- Shares of the company may be sold to investors in order to raise capital;
- Corporations, to a much greater extent sole proprietorships and partnerships, may take advantage of pension plans, medical payment plans, group life and accident plans, and other fringe benefits available under the Internal Revenue Code.
- A corporation exists forever, so long as corporate regulations are met. There is no need to cease operations if a shareholder, director, or officer dies.
How a Corporation is Taxed: C and S Corporations
A "for-profit" corporation may be taxed in one of two ways: under Subchapter C of the Internal Revenue Code (a "C" Corporation) or under Subchapter S of the Internal Revenue Code (an "S" Corporation). A corporation taxed at the entity level is known as a C corporation. Income that has been taxed at the entity level will again be taxed if, and when, is distributed as dividends to shareholders. This double taxation is, perhaps, the single greatest disadvantage to operating a business as a corporation. However, S Corporations may avoid much of this double taxation.
Requirements for S Corporation Election
To elect to be treated as an S Corporation, certain requirements must be met and an election form must be filed with the IRS. The main requirements are:
- There may be no more than 100 shareholders;
- Only one class of stock is permitted;
- Shareholders must be individuals , estates, or certain types of trusts, and must not be nonresident aliens;
If a corporation elects to be taxed as an S Corporation and meets the requirements, it will be taxed at the federal level very similarly to partnerships and limited liability companies. That is, the income, losses, and gains will be passed through directly to the shareholders and there will be no tax "at the entity level."
What is an LLC or Limited Liability Company?
A limited liability company, or LLC, may be formed by one or more owners, called members. It provides members with limited liability protection for their personal assets in most cases, just as a corporation does for its shareholders. It also offers the members with "pass-through" taxation like a sole proprietorship or partnership, avoiding the potential of double taxation in a C Corporation.
How to Form an LLC
Like a corporation, an LLC is formed at the state level by filing Articles of Organization with the Secretary of State. For a single member LLC, this is essentially all that is required to begin operating a business as an LLC. If the LLC has two or more members, they will need to enter into an operating agreement, similar to a partnership agreement, which should be in writing. This often requires the expertise of an attorney to be properly prepared, and adds to the cost of forming an LLC.
Owners and Management in an LLC
An LLC may have an unlimited number of owners and there are no restrictions on the type of persons who may be owners. One of the main advantages of an LLC over a corporation is the greater flexibility in the management of the business. An LLC may be managed in the following ways:
- solely by its members;
- by one or more managers;
- by its members and officers.
Though an LLC and an S Corporation are both "pass-through" tax entities, an LLC is not subject to the requirements that must be met in order to be an S corporation. There are no restrictions on the type of persons who may be members in an LLC. The LLC may have an unlimited number of members, and the LLC may have more than one class of equity interest. Further, an LLC, unlike an S Corporation, may provide for allocations of profits, losses, and distributions disproportionate to the percentage of equity interest held in the LLC.
Disadvantages of an LLC
Compared to a corporation, an LLC is a less favorable entity choice as far as raising capital from outside investors or offering ownership interests to employees. The corporation structure has been in existence far longer than the LLC and is better understood with respect to its structure and how ownership interests are represented in stock certificates. These characteristics have less certainty and may be more difficult to comprehend in an LLC because of the potential complexity of an LLC operating agreement.
What Are the Types of Partnerships?
When your business has to or more owners, in addition to an LLC, there are two types of partnership entities available: a general partnership or a limited partnership. (A limited liability partnership may also be available, but is generally restricted to certain types of professions or occupations and not a general purpose business.)
What is a General Partnership?
A partnership is an association of two or more persons carrying on a business venture as co-owners for profit. Next to a sole proprietorship, a general partnership is the easiest entity to form under most state laws. Although a formal written partnership agreement is not required to form a general partnership, the partners should ordinarily set forth the rights and duties in a written document. In the absence of a written agreement, however, when two or more people who engage in a business together and do not specifically choose any other entity type, they will be treated as a general partnership if there is an understanding between them that they will share in profits and losses of the business.
No Personal Liability Protection
Each partner in a partnership has personal liability for the obligations of the partnership. General partnerships are limited in their ability to raise capital from outside investors because of the prospect of potential personal liability and the usually limited market for resale of a general partnership interest.
General Partnerships Enjoy Pass-Through Taxation
One of the advantages of a general partnership is that, like a sole proprietorship, the business is not taxed. Rather, income, losses, and gains are passed through to the general partners in accordance with the allocations provided in the partnership agreement. A particular advantage to this form of business is that the partners can agree among themselves as to how income, losses, and gains are divided among the partners.
What is a Limited Partnership?
A limited partnership is a partnership in which the duties and obligations of the partners are divided between one or more "general partners," and one or more "limited partners." The formation and operation of limited partnerships are generally regulated under state statutes defining the obligations and duties of partners and imposing other obligations.
Limited Partners Have the Advantage of Limited Liability
A general partner is responsible for managing the partnership and its operations. Like the partners in a general partnership, general partners in a limited partnership are personally liable for all of the partnership's debts and obligations. A limited partner is usually not personally liable for the partnership's debts and obligations, but is prohibited from taking part in the partnership's management and day to day operations. The risk of a limited partner is usually limited to the money or other assets invested in the partnership. As a result, it is far easier to market limited liability partnership interests as an investment, particularly with respect to projects such as a real estate development.
In contrast to a general partnership, a limited partnership requires a written partnership agreement. In addition, a certificate of limited partnership must be filed in the state in which the partnership is formed. Thus, a limited partnership is normally more expensive to form a general partnership.
Partners of a limited partnership are generally taxed in the same way as partners of a general partnership. They are also given the same flexibility to allocate profits, losses, and gains regardless of the percentage of equity interest in the partnership.
What is a Limited Liability Partnership?
A limited liability partnership is an entity that is usually reserved for certain licensed professionals. Each state determines which professionals may form a limited liability partnership, but they typically include attorneys, accountants, architects, and certain medical professionals.
Licensed Professionals Have Some Limited Liability Protection
Limited liability partnerships are partnerships in which the liability of all the partners is limited. Generally the partners in limited liability partnerships are not responsible for the debts, obligations, or liabilities of the partnership resulting from negligence, malpractice or wrongful acts, or misconduct by another partner, employee, or agent of the partnership. However, a partner of a limited liability partnership is liable for other partnership debts and obligations as well as for his or her own negligence, malpractice or wrongful acts, or misconduct, and that of any person under their direct supervision and control.
How a LLP is Formed
Limited liability partnerships are formed by either filing a registration certificate with the Secretary of State, or filing a certificate to convert an existing general partnership to a limited liability partnership. Limited liability partnerships are governed like general partnerships and have a similar degree of management flexibility.
Final Thoughts on Choosing the Proper Business Type
The initial choice of an entity will usually come down to answering three basic questions:
1. Who will be the business owners?
2. How does the business expect to distribute profits to its owners?
3. Is the business expected to generate profit or losses in the early stages?
Ownership of the Business
If the business is owned by one individual who does not expect to add ownership interests, then the management structure and flexibility is not of particular concern and any of the above business entities other than partnerships may be appropriate. The owner's decision will depend more on tax considerations and personal liability protection.
Distribution of Profits or Keeping Cash in the Business
If the objective of the owners is to distribute the profits of the business each year, they will want an entity type that allows for "pass-through" taxation. On the other hand, if the owners intend to expand the business, use profits to purchase equipment, additional raw materials, or accumulate cash for future business purposes, a C Corporation may be the best choice.
If it's anticipated that the business will have operating losses in its first year or two, the owners may prefer an entity that allows "pass-through" taxation so that losses may be used to offset income from other sources.
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