The two main areas of consideration when choosing a type of business entity are legal and taxation. For legal purposes, do you need to protect your assets from judgments that may arise from lawsuits against your company? Is it important to you that your business continues if you no longer actively participate in it? Because each entity is taxed differently, it is important to know how the business income will be taxed.
The decisions you make at the onset of your business can have long-term implications, so you should consider consulting with an attorney and accountant or perform sufficient research in order to make an informed decision.
The following is a brief description of the various types of entities. Consider these a starting point in your decision-making process as opposed to a sole source of information about business entities.
Sole Proprietorship. As in Marla’s case, many small businesses start off as sole proprietorships because they are the easiest and least expensive to form. These are usually a one-person operation where the owner performs all the duties of running the business and assumes all the liabilities associated with the business. Setting up this type of entity is very straightforward. There is no formation paperwork to complete as there is for corporations, partnerships and LLCs. For tax purposes, appropriate forms reporting the business activities are attached to your personal returns, so no separate returns are necessary.
Some of the disadvantages to sole proprietorships are that the owner has unlimited liability, and both personal and business assets can be at risk. Also, business financing may be more challenging for sole proprietorships, and there is no way to bring in outside capital contributors. As a result, owners have to utilize personal funds and credit sources. Unlike corporations or partnerships, there is no business continuation provision, which means that the business ceases when the owner dies.
Limited Liability Company (LLC). These legal entities are formed under state law and are designed to provide the limited personal liability feature of a corporation and the tax efficiencies and operational flexibility of other entity structures. Single-member LLCs are usually treated as disregarded entities and taxed directly to their owner, such as in the case of a sole proprietor or rental property, or you can choose to be taxed as a corporation. An LLC with two or more members is generally classified as a partnership for tax purposes unless you elect to be taxed as a corporation. The main advantage to this type of structure is that you do not have to observe corporate formalities such as annual meetings and election of officers. The main disadvantage is the inconsistent treatment between states of this type of structure.
Partnership. Two or more persons agree to own and operate a business. Profits and losses are shared and reported directly on the partners’ personal tax returns by way of a partnership tax return. These entities are relatively easy to establish. However, you should invest time in developing the partnership agreement, which should cover such areas as: how profits/losses are to be divided; who is responsible for decision-making; how disputes will be resolved; how new partners will be admitted and existing partners be bought out; and how dissolution will take place. The main disadvantage to partnerships is there is unlimited personal liability for the general partners.
Corporation. This business entity carries its own legal status, sole and separate from its owners, the shareholders. It can be taxed, sued and enter into contracts. Some of the advantages to this choice of business entity are that the corporation has a life of its own, and a transfer of ownership is easy. Liability rests primarily with the corporation, not its shareholders. Some of the disadvantages are that organizing a corporation is difficult, and it must comply with federal and state regulations. Incorporating may result in higher overall taxes. The corporation must hold periodic meetings and keep minutes.
Subchapter S Corporation. A corporation can make a tax election (through IRS Form 2553) that enables the shareholder to treat earnings and profits as distributions and have them pass through to their personal tax return. This type of corporation is limited to domestic corporations with only one class of stock and less than 100 shareholders, as long as no shareholder is another corporation. Employee-shareholders must pay themselves a “reasonable” wage based on local compensation for similar work. Because this is an election of a corporation, advantages and disadvantages are similar to those of corporations except that the double taxation issue arising from the payout of dividends does not apply to S corporations.
There are a lot of factors to consider in your choice for a business entity and well worth the time to explore each one with your advisors.