Introduction to selecting a Business Entity

If you are very good at what you do and know the business area for your set of skills then one of the most effective ways to create wealth is to start and operate your own business. When you operate your own business there are significantly less limits on your income than the alternative of being an employee with a job. There are also significant tax advantages to operating your own business. If you decide to go into business for yourself then one of the most important decisions, you will make is the choice of entity type. Each entity type (i.e., business form that has legal rights and obligations) has advantages and disadvantages. There is not a best legal entity type for everyone. Which entity is best for you depends on your unique situation and that can change over time. I changed my entity type as my business matured.

 

Below is a list of business entities available to tax payers along with a brief summary of some advantages and disadvantages.

 

  • Sole Proprietorship

The sole proprietorship is the most commonly used business entity. It is not a legal entity separate of apart from its owner. The income or loss is reported on the schedule C of the owners from 1040.

Advantages: Easiest to establish and requires no special forms, profits are only taxed once on owner’s personal return, owner has complete control & makes all decisions, tax forms are not complicated, assets are easy to liquidate at death of owner.

Disadvantages: owner has unlimited liability, the owner’s personal assets are exposed without limitation to any business debts/liabilities.  The business can’t be transferred. The owner reports the sale as if each asset were sold, borrowing money is more difficult, can’t accept capital from outside investors.

 

  • C Corporation

Corporations were created to limit the liability of the owners. The C Corp files a separate return from its owners.

Advantages: Owners personal assets are protected from creditors. Creditors can only go to the corporation for settlement of debts, can sell stock, issue bonds, & get bank loans to raise capital.

Disadvantages: C corporations are double taxed. First the income is taxed to the corporation as it is earned and second the income is taxed when the corporation distributes the income in fhe form of dividends. Closely held C corporations are subject to At Risk rules which means the tax laws limit the amount of losses an investor (e.g. limited partner) can claim (only the amount at risk can be deducted). C Corporations are a complex business structure.

 

  • S Corporation

The S Corporation is a special type of corporation that is not taxed and the income is passed through and taxed to the shareholders. Over one half of all corporations are S corporations. They tend to be small in size and number of owners.

Advantages: Owners personal assets are protected from creditors like the C corporation, no double taxation because income is passed to owners, lenders work with S Corps.

Disadvantages: Must file articles of incorp with the state, limited to 100 shareholders, can only have 1 class of stock, fringe benefits provided to shareholders and employees are taxed as compensation, ownership restrictions.

 

  • Partnerships

A partnership is a sole proprietorship with more than one owner. There are several forms of partnerships available to taxpayers (general, limited, limited liability)

Advantages: Easy to form, Use different talents to share in running the business, continues if one partner dies, Income is taxed once because the income flows through and is taxed on each owner’s personal tax return.

Disadvantage: Unlimited liability, Owners are held liable for partnership debts (this is for a general partnership), management conflicts if owners disagree (no one person is in charge), partners share of the profits may not be adequate for their contribution.

There are limited partnerships where owners are divided into general partners and limited partners. Limited partners have only limited liability, but they are not allowed to participate in the operation of the business. A “limited liability partnership” is used mostly by personal service taxpayers.

 

  • Limited Liability Companies (LLCs)

The LCC is a noncorporate hybrid business structure that combines the tax advantages of a general partnership with the limited liability of a corporation.

Advantages: Complete pass through tax advantage to owners, operational flexibility of a partnership, limited liability (like a corporation), no restrictions on numbers and types of members/shareholders, members participate in the management of the LLC and share in profits as owners/shareholders, owners choose how pay taxes(as proprietorship, partnership, or corporation), most states don’t require annual mtgs, no requirements for a board of directors.

Disadvantages: Accounting and legal costs are higher than proprietorships, must file articles of incorporation with state, owners must define operating agreement that defines decision making authority, may cease to exist at death of a member unless specified in operating agreement.

 

This was a brief introduction. If you would like to learn more details to see which is best for your business, you can reach me at my phone number or email address shown on this website.