How To Choose The Right Business Entity

 

 

Choosing the right business entity allows an entrepreneur to protects themselves and the business. The main goal of entity formation is to reduce liability exposure & minimize taxes. Competent entity formation also ensures that longevity of the business, rather than being automatically terminated, upon the death of an owner. Formalizing the business also clarifies the ownership of all participants in the business.

When choosing a business entity, you should consider three main points: (1) to what extent your personal assets are at risk from liabilities arising from your business; (2) how to best gain the best  tax advantages and avoid multiple layers of taxation; (3) the costs of operating and maintaining the business entity.Despite the implication in this blog post 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 ultimately involve weighing the advantages and the disadvantages of several factors that apply to your particular business. What Do I Have to Choose From??

SOLE PROPRIETORSHIP

A sole proprietorship is the simplest and most common structure chosen to start a business. It is an unincorporated business owned and run by one individual with no distinction between the business and you, the owner. In other words, YOU are the business.

There are no organizational rules to follow, and there is virtually nothing that an owner needs to do to begin operating as a sole proprietor. The sole proprietor has total control and decision making authority, and are entitled to all profits and are responsible for all your business’s debts, losses and liabilities.

Advantages of a Sole Proprietorship

Easy and inexpensive to form: A sole proprietorship is the simplest and least expensive business structure to establish. Costs are minimal, with legal costs limited to obtaining the necessary license or permits.

Complete control. Because you are the sole owner of the business, you have complete control over all decisions. You aren’t required to consult with anyone else when you need to make decisions or want to make changes.

Easy tax preparation. Your business is not taxed separately, so it’s easy to fulfill the tax reporting requirements for a sole proprietorship. The tax rates are also the lowest of the business structures.

Disadvantages of a Sole Proprietorship

Unlimited personal liability. Because there is no legal separation between you and your business, you can be held personally liable for the debts and obligations of the business. This risk extends to any liabilities incurred as a result of employee actions.

Hard to raise funds and build business credit. Sole proprietors often face challenges when trying to raise money. Because you can’t sell stock in the business, investors won't often invest. Banks are also hesitant to lend to a sole proprietorship because of a perceived lack of credibility when it comes to repayment if the business fails.

Heavy burden. The flipside of complete control is the burden and pressure it can impose. You alone are ultimately responsible for the successes and failures of your business.

PARTNERSHIP

A partnership is a legal entity in which two or more people operate a business jointly with the purpose of earning and sharing profit. There are two types of partnership entities available: a general partnership or a limited partnership:

GENERAL PARTNERSHIP

A general partnership is a type of partnership that is formed by two or more people who agree to share all losses and profits of the company. 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.

Advantages of a General Partnership

Easy tax preparation. General partnerships does need to file an information return, but because the business is a pass-through entity, each member pays individual income tax on earnings.

Easy Expansion. When a general partnership moves to another state, it is able to share the ease of transfer that a sole proprietorship enjoys. The partnership simply needs to be registered in the new state, and potentially file a DBA if necessary.

Profit retention. All profits from a general partnership are split equally between the members unless stated otherwise in the articles of partnership. There are no shareholders in a general partnership, so profits are able to flow through to each member.

Disadvantages of a General Partnership

  • Unlimited personal liability. 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.

  • Continuity of the organization: Because a general partnership is comprised of two or more individuals, if one member leaves the company or dies, the partnership is dissolved. This can be avoided if an ownership transfer plan has been drawn up.

  • 50/50 Control: Each member of a general partnership has a predetermined percentage of control or say in major company decisions. Typically with two partners, that control is split 50/50. In the case of more than 2 partners, a 2/3 vote must be achieved for major decisions.

LIMITED PARTNERSHIP

A limited partnership is similar to a general partnership in many ways, but has one key difference. At least one or more member must be a general partner, and at least one or more member must be a limited partner. A general partner is one who runs the day-to-day transactions and makes the decisions for the business, while a limited partner is simply a passive investor. Limited partners are not allowed to make decisions for the company. In contrast to a general partner who carries unlimited liability, a limited partner only risks losing their capital contribution.

Advantages of a Limited Partnership

Limited Liability. A limited partner enjoys limited liability where only his or her capital investment is at risk.

Income taxes. Contrast to general partners, limited partners can't deduct any losses from their income, and must claim their portion of the income paid to them on their personal taxes. The limited partnership as a whole is not taxed federally, but it must file an information return. Then each member files separate and individual income taxes.

Continuity of the organization. If a limited partner dies or leaves the business, the business can continue. A personal representative of the limited partner is entitled to the deceased's portion of the assets and deferred profit.

Disadvantages of a General Partnership

No Control. Since limited partner enjoys limited liability, he or she is not allowed to participate in the day-to-day transactions, or practice any control over business decisions.

C-CORPORATION

A corporation (sometimes referred to as a C corporation) is an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs.

Corporations are more complex than other business structures because they tend to have costly administrative fees and complex tax and legal requirements. Because of these issues, corporations are generally suggested for established, larger companies with multiple employees.

Advantages of a Corporation

Limited Liability. When it comes to taking responsibility for business debts and actions of a corporation, shareholders’ personal assets are protected. Shareholders can generally only be held accountable for their investment in stock of the company.

Ability to Generate Capital. Corporations have an advantage when it comes to raising capital for their business - the ability to raise funds through the sale of stock.

Corporate Tax Treatment. Corporations file taxes separately from their owners. Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends, while any additional profits are awarded a corporate tax rate, which is usually lower than a personal income tax rate.

Attractive to Potential Employees. Corporations are generally able to attract and hire high-quality and motivated employees because they offer competitive benefits and the potential for partial ownership through stock options.

Disadvantages of a Corporation

Time and Money. Corporations are costly and time-consuming ventures to start and operate. Incorporating requires start-up, operating and tax costs that most other structures do not require.

Double Taxing. In some cases, corporations are taxed twice - first, when the company makes a profit, and again when dividends are paid to shareholders.

Additional Paperwork. Because corporations are highly regulated by federal, state, and in some cases local agencies, there are increased paperwork and recordkeeping burdens associated with this entity.

S-CORPORATION

An S corporation (sometimes referred to as an S Corp) is a special type of corporation created through an IRS tax election.

An S corp is a corporation with the Subchapter S designation from the IRS. To be considered an S corp, you must first charter a business as a corporation in the state where it is headquartered. According to the IRS, S corporations are "considered by law to be a unique entity, separate and apart from those who own it." This limits the financial liability for which you (the owner, or "shareholder") are responsible. Nevertheless, liability protection is limited - S corps do not necessarily shield you from all litigation such as an employee’s tort actions as a result of a workplace incident.

Advantages of an S Corporation

Tax Savings. One of the best features of the S Corp is the tax savings for you and your business. Like Donald Trump Tax Savings! One more time, Like Donald Trump Tax Savings! S corporations avoid the double taxation that C corporations unfortunately experience. S corporations are pass-through entities, and all the taxable income ends up going to the shareholders, who pay individual income tax. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a "distribution," which is taxed at a lower rate, if at all. Also, business expenses can be deducted from the income claimed on taxes for S corporations, similar to C corporations.

Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, than benefits like health and life insurance are deemed taxable income.

Independent Life. An S corp designation also allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the company, or sells his or her shares, the S corp can continue doing business relatively undisturbed. Maintaining the business as a distinct corporate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.

Disadvantages of an S Corporation

Stricter Operational Processes. As a separate structure, S corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers and records maintenance.

Shareholder Compensation Requirements. A shareholder must receive reasonable compensation. The IRS takes notice of shareholder red flags like low salary/high distribution combinations, and may reclassify your distributions as wages. You could pay a higher employment tax because of an audit with these results.

LIMITED LIABILITY COMPANY

Limited liability companies, LLC are specials forms of enterprises that combine the benefits of partnerships and corporations with limited liability. They are very similar to partnerships, but are not burdened with the same unlimited liability that partnerships carry.

LLCs are very popular entity types because they don't require double taxation like C corporations do, and all profits are passed-through to owners. There are fewer startup costs and less paperwork to be completed with an LLC versus an S corporation. Unlike corporations, LLCs are dissolved when a member leaves or dies. The other disadvantage of an LLC is the self-employment tax that is imposed upon this type of business, which can be higher than corporate taxes.

 

Advantages of an LLC

Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members' personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means "limited" liability - members are not necessarily shielded from wrongful acts, including those of their employees.

Less Recordkeeping. An LLC's operational ease is one of its greatest advantages. Compared to an S-Corporation, there is less registration paperwork and there are smaller start-up costs.

Sharing of Profits. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity. Consequently, it's up to the members themselves to decide who has earned what percentage of the profits or losses.

Disadvantages of an LLC

Limited Life. In many states, when a member leaves an LLC, the business is dissolved and the members must fulfill all remaining legal and business obligations to close the business. The remaining members can decide if they want to start a new LLC or part ways. However, you can include provisions in your operating agreement to prolong the life of the LLC if a member decides to leave the business.

Self-Employment Taxes. Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax. If you decided to form an LLC, make sure you are taxed as an S-CORP!

 

If you’ve read this post and now you're thinking that maybe you should change your entity to obtain better protection. Don’t worry! Most entity changes are simple and there is likely a small fee associated with the change depending on the state you are forming in. However, most of these changes require a new federal Employer Identification Number (EIN). In some situations, employers are eligible to carry over wages from their old EIN to their new EIN. This means that the wages the employees earned with the old business are applied to the wage base limits for Social Security and unemployment taxes for the new business, which can reduce the new business's employment tax liabilities. While all of these scenarios are very similar in nature, there is no one standard procedure the employer has to follow. Each entity change is different and has its own unique set of circumstances.