How to Select the Best Business Entity for Your Business
Prior to starting a business, it is critical for the owner(s) to determine how she/he wants it to be structured (legal entity). Choices include Sole Proprietorship, General Partnership, Limited Partnership, Limited Liability Company, C-Corporation, and S-Corporation. Each entity has a set of characteristics, benefits, and limitations that should be considered thoroughly before selecting it. (Print out this free Business Entities and Their Characteristics Chart as a reference.)
Sole Proprietorship and Partnerships
Most small businesses begin as a sole proprietorship or some form of partnership. When either of these business entities is chosen, the owners (or partners) are personally responsible or liable for that business. This, of course, means that the owners can be personally sued and if they do not have enough liability insurance to cover charges (from judgments, debts, or law suits), they run the risk of having their personal assets attached (i.e. liens on personal property, vehicles, and savings accounts).
Sole Proprietorships are in fact “the business” which means that they are not incorporated and at the end of the month, quarter, or year, what the business owes, the owner owes and what the business reaps, the owner reaps. Some advantages and disadvantages exist with being a sole proprietorship:
- Owners have the flexibility of changing the business quickly as need arises;
- Owners can operate the business under their own name or trade name (dba);
- Owners govern themselves — without articles or directors;
- Owners have no limits on liability;
- Owners have no tax distinction between them and their business;
- Owners’ profit is income on the owner’s income tax return.
Partnerships are much like a marriage which means that often times friends or family members become enemies over time. Personalities can conflict or partners may end up thinking that the other is not contributing as much. When two people form a partnership (general or limited), agreements should be in place outlining how much money and/or assets are being invested into the business, what each other’s roles are in the business, and other factors which might include exit strategies and what happens in case of the death of a partner. The major problem with a partnership is that each person shares equally in the business so they govern together – again, causing possible problems regarding ideas, values, and practices. Likewise, both parties are liable (except limited liability partnerships). In limited liability partnerships (where the partners receive limited liability protection), limited partnership agreement must be filed.
Limited Liability Company (LLC)
A Limited Liability Company is a popular structure for small businesses because, in most cases, the owner’s personal assets are shielded from the business, it is easier and less expense to set up than a corporation, and the tax breaks are greater than those of a sole proprietorship. Even though some states allow single members (owners are called members) to form LLC’s, owners in some of those states are not protected if they are the only principals in the business. When forming a LLC, owners can spend as little as $50 (in some states) and submit the paperwork themselves. In other states and when the complexity of the company could possible cause major issues, it is best to hire an attorney. Regardless, the cost is less than incorporating. Besides the liability and legal issues, the type of business chosen determines the business’s tax structure as well. Since an LLC classification (established through the state) is not recognized by the U. S. Government, its members must decide whether to file federally as a corporation, sole proprietorship or partnership at the end of the year.
In essence, a corporation is a company that is structured in a way that it requires a “certificate and articles of incorporation” to do business. Operations are conducted under rules and bylaws, overseen by governing bodies (consisting of officers, boards of directors and stockholders) to ensure compliance and ensure distribution of earnings. The term “C-Corporation” refers to how the profits are taxed (subchapter C under the IRS Code). In this case, they are doubly taxed (the corporation and the shareholder’s dividends), but the rates are usually less than that of individuals. Likewise, a corporation can benefit from different deductions unavailable to individuals. Profits are split between the corporation and its owners (again, saving in taxes).
A C-Corporation can have any number of owners or shareholders and must be incorporated by the state. The officers manage the corporation while the shareholders own the business and elect a Board of Directors to govern. The shareholders (people who have exchanged money for capital stock in the business) have limited liability, meaning that they are not personally liable for the corporation’s debts or can be personally sued when the corporation is sued.
Like C-Corporations, S-Corporations get their names from IRS’s subchapter S. Instead of paying federal income taxes, their profits or losses are “passed through” to shareholders to report on their individual income tax returns. The structure results in “single taxation” which benefits small businesses. The business cannot have over 100 shareholders (must be US citizens) and must be located within the US. S-Corporations are allowed to write-off startup losses and they have a reduction in taxable gains. Since they are limited in number and shareholders pay taxes on profits, this type of corporation may not appeal to all businesses.
Selecting the Right Business Entity
This article has been designed to draw attention to the various types of business entities and is not all inclusive in information about each entity. Therefore, this information has not been intended to replace professional advice. Instead, small businesses should consult with qualified tax accountants, lawyers, and advisors before making a decision on the legal entity of their business. By doing so, they are ensuring that they have made an educated choice.