When you’re first starting a business, one of the most important and far-reaching decisions you can make is selecting the best business entity. It may not be a decision that you’re excited about making – even if you’ve created a cool name that matches your equally brilliant business idea – but it will definitely affect your company’s ability to be successful.
The type of entity you choose is important because it may affect the number and identity of potential shareholders and partners, equity structure, and control and management. Moreover, it will determine the types of funding for which you may qualify.
There’s no dodging the time and thought you have to put into considering all of your options, either. You can’t just pick randomly and then go back and change it if it doesn’t work. Well, you can, but it may cost you dearly in terms of tax and other financial consequences. So, committing to a complete analysis to make the correct choice right from the get-go is vital.
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 best to 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.
The following are two other important early considerations, when you’re selecting an entity type:
● Who's running the show. Entity choice happens at the state, not the federal level. You incorporate or organize your business at the state level. Because the laws governing entity types vary from state to state, not all entity choices are recognized or treated the same way in every state.
● It's not all about taxes. This is where it starts to get a little complicated. You need to know up front that your corporate entity choice may be entirely different from your tax identity status. Incorporating or organizing with the Department of State in your state does not qualify as a tax identity with the Internal Revenue Service (IRS). In other words, you can organize as an LLC, but still choose to be taxed as a partnership, S corporation, or C corporation for example. As another example, you may incorporate as a C corporation but notify the IRS that you prefer to be taxed as an S corporation.
You have numerous choices to consider, so let’s take a look at the most common options available for business entity classification. The business structure you choose will have legal and tax implications. The following information will provide a brief introduction to each of the primary categories to help you determine which is best suited for your business so you can choose your optimum business structure.
A sole proprietorship is the most basic type of business to establish. You alone own the company and are responsible for its assets and liabilities, so you don’t have to sign any documents or submit any forms to the state. The downside is that you can be personally liable for the debts and obligations of the business.
Thus, for liability purposes, personal assets such as your house may be considered business assets. Additionally, your income and expenses from the business are reported on your individual federal tax Form 1040, Schedule C. Since you are limited as a taxpayer to taking personal deductions for specific expenses, such as medical expenses, that may result in a less favorable tax result in certain circumstances.
Limited Liability Company
An LLC is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Possibly the most popular form of business entity, an LLC is made up of members, as opposed to shareholders. Individual members are typically protected from liability so long as they register with the state and follow state laws (such as filing annual reports). On the plus side, LLCs have far fewer corporate formalities than other corporations do. For federal tax purposes, most LLCs are taxed as a partnership because it's typically more advantageous; there may be situations when corporate tax treatment is preferred. Moreover, as an LLC, you can choose to be taxed as an S corporation. In any case, you’ll want to verify which approach would be best according to the laws of your state.
A corporation is more complex and is generally suggested for larger, established companies with multiple employees. Typically, the business is owned by individual shareholders who hold stock certificates or shares. The shareholders vote on policy issues, but the decisions on company policy are left to the board of directors, who are elected by the shareholders. The daily operations are performed by the officers – such as the CEO and the executive team – of the corporation. A C corporation offers limited liability, since shareholders are not usually responsible for the debts, obligations and actions of the company.
An S corporation is similar to a C corporation, but is taxed only on the personal level. An S Corporation is a bit tricky, because the term actually refers to a tax election. That means that another entity (a corporation, LLC or professional corporation) is created at the state level and an election is made to be taxed as an S corporation. By federal law, S corporations have a number of restrictions: they must have only one class of stock and have a limited number of domestic (no foreign) shareholders.
On the plus side, LLCs have far fewer corporate formalities than other corporations do.
The S corporation status does offer benefits regarding compensation, as S corporations may opt to pay out reasonable compensation to small business owners and treat the remainder as a distribution that isn’t subject to payroll taxes (Social Security and Medicare). Compensation, however, is subject to payroll taxes. With monies paid out that qualify as a distribution, the tax savings can be notable, since the employer and employee payroll taxes in a small business typically come from the same coffers. Caution: The IRS does not favor that arrangement, so it may lead to an audit. One important point is that if you have elected to be treated as an S corporation but don’t follow all of the requirements, you could lose that status and revert to a C corporation. That could have important consequences for your business.
There are several different types of partnerships, depending on the nature of the arrangement and partner responsibility for the business. General partnerships, for example, are almost as easy to form as a sole proprietorship is; they are associations of two or more persons to carry on a business for profit. In most states, there are no documents and no formal processes necessary to form a partnership. In a general partnership, partners share in the liability for business obligations.
A limited partnership differs slightly because it is defined as a partnership formed by one or more general partners and one or more limited partners. General partners have joint and several liabilities for the debts of the partnership and often exercise control over the partnership. Limited partners also may have limited liability, depending on state law and how much control they exercise. Each partner is responsible for reporting that information on their individual tax returns.
A fairly new type of entity, a limited liability partnership (LLP), is similar to a general partnership. However, while a general partnership can exist on an informal basis, an LLP must register with the state. The benefit of the formal acknowledgement is that the LLP then assumes a form of limited liability similar to that of a corporation. So, typically, no one partner is liable for another partner's malpractice, for example, though the level of liability can vary from state to state. Although it will vary by state, there is generally unlimited personal liability for contractual obligations of the partnership, such as promissory notes and mortgages.
Some states recognize a limited liability limited partnership (LLLP). While an LLP is a general partnership with limited liability, an LLLP is a limited partnership with limited liability.
Both an LLP and an LLLP are treated as pass-through entities, similar to a general partnership, for federal tax purposes.
In addition to formalizing the business by clarifying the ownership of all its participants, there is one other critical benefit that we haven’t mentioned. Choosing the right business entity provides business owners with a tool to ensure that the business’ operations will continue, rather than being automatically terminated, upon the death of an owner.