When forming your company, there are four basic categories of business entities to choose from, and each comes with its own set of pros and cons. The one you choose for your particular business will depend primarily on three key factors – liability, taxation and recordkeeping – and the choice you make will define the structure of your business and set you on the track toward achieving your business goals.
Types of Business Entities:
- Sole proprietorship
- Limited liability company (LLC)
Advantages and Disadvantages of Each Business Entity
The simplest structure is the sole proprietorship, which usually involves just one individual who owns and operates the enterprise. With this structure, business earnings are taxed only once, and income and expenses from the business are included on the owner’s personal income tax return. Additionally, business losses you suffer may offset income earned from other sources.
However, there are several disadvantages to this form, the biggest of which is personal liability for business debts. This means that with a sole proprietorship, the owner’s personal assets are at risk from business creditors. Raising money for a sole proprietorship can also be difficult. Generally, banks and other financing sources are reluctant to make business loans to sole proprietorships. In most cases, the business owner will have to depend on its own financing sources, such as savings, home equity or private loans from sources such as friends and family.
A partnership is a business form that’s used when the business will be owned and operated by two or more individuals or entities. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the business and are not subject to the same liabilities as the general partners.
One of the major advantages of a partnership is the tax treatment it enjoys. A partnership doesn’t pay tax on its income but “passes through” any profits or losses to the individual partners. Even though the partnership pays no income tax, it must compute its income and report it on a separate informational return to the IRS. However, personal liability is a major concern for general partners. Similar to a sole proprietorship, general partners are personally liable for the partnership’s obligations and debt. Moreover, unless it is expected to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. Keep in mind that partnerships are more expensive to establish than sole proprietorships because they require more extensive legal and accounting services.
In the absence of an agreement that states otherwise, each general partner can act on behalf of the partnership, take out loans and make business decisions that will affect and be binding on all the partners. It is strongly suggested that any proposed or existing partnership take the time and incur the expense to have a partnership agreement put in place to memorialize, among other things, how the partnership will be managed and how profits and losses will be distributed among the partners.
A corporation is an independent legal entity, separate from its owners. Like a person, the corporation can be taxed and can be held legally liable for its actions. The corporation can also make a profit. A corporation’s debt, generally speaking, is not considered the debt of its owners (assuming the owners did not personally guarantee the debts), and thus, the owner’s personal assets may be protected from liability. There are, however, some instances in which personal liability can be imposed on the owners of a corporation, but those are in extraordinary circumstances and the subject of a different article.
A corporation may retain some of its profits without the owner paying tax on them, and it also has the ability to raise money through the sale of stock (either common or preferred). Corporations also continue indefinitely, even if one of the shareholders dies, sells the shares or becomes disabled.
The corporate structure, however, comes with a number of downsides. Each state has its own laws and regulations for corporations, which can impose burdensome recordkeeping, taxes and fees. Moreover, unless filed as an “S” Corporation (described below), owners of a corporation pay a double tax on the business’s earnings, which means that not only is the corporation taxed on earnings, but distributions made to the shareholders in the form of dividends are also taxed. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are also taxed. However, accounting professionals can, in some instances, help reduce those tax obligations.
An S Corporation shares almost all of the benefits described above. A significant difference when filing as an S corporation, however, is that there is only single taxation on earnings, where income and losses are passed through to shareholders and included on their individual tax returns. However, an S corporation can only issue common stock, meaning that they cannot issue preferred shares. S Corporations also have a limitation and cap on the total number of shareholders.
Limited Liability Companies (LLC)
An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations. LLCs were created to provide business owners with the liability protection that corporations enjoy without the downside of double taxation. Earnings and losses, like the partnership and S Corporation, pass through to the owners (which are called members). An LLC offers no limitation on the number of owners the business can have, unlike an S corporation, which is limited. In addition, generally and subject to the terms of an agreement managing the LLC, any owner of the LLC is allowed a full participatory role in the business’s operation; in a limited partnership, on the other hand, limited partners aren’t permitted any say in the operation.
Other advantages to the LLC are:
- Flexible management. A “member” (shareholder equivalent) can be a person, partnership or corporation. Members get a percentage of ownership of the business; and
- Flexible distribution. Profits and losses don’t have to be distributed in proportion to the money each member puts in. A regular C corporation cannot allocate profits and losses. And in a subchapter S corporation (taxed as a partnership), profits and losses are in proportion to shares held.
LLCs also have their disadvantages. If you plan to operate in several states, you must determine how a state will treat an LLC formed in another state. LLCs aren’t ideal if owners want to give fringe benefits to themselves or employees. Unlike with a C corporation, you can’t deduct the cost of benefits with an LLC. And since there’s no stock, you can’t use stock options as incentives for your employees. If the members work for the LLC, those members pay self-employment taxes, which is the Medicare/Social Security tax paid by entrepreneurs.
Selecting a Business Entity
When making a decision about the type of business to form, you should first consult with your trusted professionals – among them, your accountant, lawyer and financial advisor. When consulting with these professionals, you’ll want to consider and evaluate all of the various nuances for each type of business entity, which include:
- Legal liability. To what extent does the owner need to be insulated from legal liability and protect personal assets?
- Tax implications. Based on the individual situation and goals of the business owner, what are the opportunities to minimize taxation?
- Cost of recordkeeping. How much will it cost to form and maintain proper administration and recordkeeping?
- Flexibility. Owners must consider how flexible the entity needs to be. Your goal is to maximize the flexibility of the ownership structure by considering the unique needs of the business as well as the personal needs of the owner or owners – a critical consideration. No two business situations will be the same, particularly when multiple owners are involved, and no two people will have the same goals, concerns or personal financial situations.
- Future needs. What do you envision the business to look like in the future (i.e. years down the road)? How will you handle the death of an owner, sale of the business, etc.?
Ultimately, choosing the right entity for your business is not a decision you want to make alone. The advice of legal, accounting and financial advisors is extremely important in making this decision because of the present and future benefits and ramifications that can take place.
Still, even after you settle on a business structure, remember that the circumstances that make one type of business organization favorable are always subject to changes in the laws. It makes sense to reassess your form of business from time to time to make sure you’re using the one that provides the most benefits.
Don’t take this very important decision lightly, and don’t make a choice based on what somebody else has done. Carefully consider the unique needs of your business and its owners, and seek expert advice, before settling on a particular business format.
For additional help determining the right business entity type for your company, contact us today to schedule a consultation.