How to choose a business entity with confidence
Are you an entrepreneur looking to start your own small business? With so many things to do, deciding on a business entity might be the last thing on your mind. Maybe you're confused where to even start with questions like:
- When do I choose the type of business entity?
- What are the different types of businesses I can create?
- Can I change the type of business later?
I passed a truck on the freeway last week that had a homemade sign taped to the side of driver's door. The sign had his logo with the word 'inc' added to the end of it. From my brief glance at the single passenger, I wondered why a seemingly one-man company would want to be incorporated. I wanted to write this post today because I realized that new entrepreneurs need a resource when deciding on this crucial first step!
I'll make it (relatively) painless in this blog post for you to pick the form of business that works best for your company. Everything you need to know about choosing your business entity is here, so keep reading!
TYPES OF BUSINESS ENTITIES - SUMMARY
- SOLE PROPRIETORSHIP
A sole proprietorship is the most simple and easy form of business. The sole proprietor is a single owner without any differentiation between the business and the individual. YOU are the business. A sole proprietorship offers the easiest way to set up a business. Income taxes are simple and filed by the individual and business as one. This type of business has its disadvantages as well. With the ease and autonomy of the sole proprietorship comes unlimited liability as well. The owner's personal assets would be put at risk if the business were ever sued. If the owner were to die, the business would die with him or her. Unfortunately the sole proprietorship's funds are also limited to whatever credit or existing funds the owner can personally obtain.
- GENERAL PARTNERSHIP
A general partnership is a type of partnership that is formed by two or more people who agree to share all losses and profits of the company. Each member of a general partnership is fully engaged and active in the firm, carrying the ability to make decisions and act on behalf of the partnership. The partnership can be created through an oral or written agreement. The dissolution of a partnership can be messy if an ownership transfer plan is not created prior to creation of the company. If any partner dies, and the partnership does not have a plan set in place, the partnership as a company ceases to exist. The general partnership shares in the same disadvantage as a sole proprietor where each member's personal assets are subject to creditors or being sued. One advantage of this type of business is the ability for each member to keep the profits. The partnership itself does not have to pay federal income tax- rather each member in the partnership is required to claim their individual earnings on their personal taxes.
- LIMITED PARTNERSHIP
A limited partnership is similar to a general partnership in many ways, but has one key difference. At least one or more member must be a general partner, and at least one or more member must be a limited partner. A general partner is one who runs the day-to-day transactions and makes the decisions for the business, while a limited partner is simply a passive investor. Limited partners are not allowed to make decisions for the company. In contrast to a general partner who carries unlimited liability, a limited partner only risks losing their capital contribution.
This sort of partnership is beneficial to both the general partner and the limited partner because it allows additional capital to be added to the business without adding an extra decision maker. Limited partners usually receive a portion of the profits. In contrast to a general partnership, when a limited member dies, the personal representative receives the deceased's portion of the assets and deferred profits. While the death of a general partner can dissolve the business, the death of a limited partner does not.
Although owned by many individuals, called shareholders, C corporations are considered to be its own entity, or person, in the eyes of the law. While they are technically invisible, C corporations are separate entities from those individuals who hold its stock. This type of business is held to many of the same laws that apply to individuals, but also has additional requirements for tax purposes. If the corporation decides to operate in more than one state, then it will be subject to that state's statutory laws, as well as federal law.
S corporations are businesses that are specially created through IRS tax election. Like C corporations, S corporations are also separate entities from their owners. The main difference of an S corporation is the tax treatment they receive. They are a great option for small business owners because they protect the personal assets of the business owners through limited liability, while allowing for pass-through income. Any losses can be deducted to offset one's personal tax return a huge benefit to being an S corporation is the avoidance of paying double taxes. Some states do require more work to be performed as an S corporation in the form of ongoing fees and annual reports. Ownerships can easily be transferred from one person to another, without facing severe tax penalties or accounting difficulties. However, S corporations are only allowed to have one type of stock and only one hundred or fewer shareholders.
- LIMITED LIABILITY COMPANY
Limited liability companies are specials forms of enterprises that combine the benefits of partnerships and corporations with limited liability. They are very similar to partnerships, but are not burdened with the same unlimited liability that partnerships carry. LLCs are advantageous because they don't require double taxation like C corporations do, and all profits are passed-through to owners. There are fewer startup costs and less paperwork to be completed with an LLC versus an S corporation. Unlike corporations, LLCs are dissolved when a member leaves or dies. The other disadvantage of an LLC is the self-employment tax that is imposed upon this type of business, which can be higher than corporate taxes.
TYPE OF BUSINESS ENTITIES - THE DETAILS
- Liability: Unfortunately with a sole proprietorship, the liability is unlimited. This means that the owner can be held entirely responsible for debt to creditors or if a lawsuit is won against him or her etc. In such a case, the business assets are not protected, nor are the personal assets of the owner. If the business owner gets himself or herself into trouble financially, the effects can be long term. Even if the business closes, the owner is still obligated to any debts. Those to whom the debts are owed can obtain payment from the sole proprietor's personal assets, if available.
- Income taxes: The money earned by the sole proprietor is taxed as a single unit because the owner and the business are considered to be one and the same in the eyes of the law. Business expenses are able to be subtracted from the income so that the sole proprietor is not taxed on them. Taxes are paid only once by the owner at the end of the year when taxes are filed. The taxes are filed as personal income tax under federal and state tax requirements. These state income taxes can vary from state to state. There are no federal tax obligations for a sole proprietorship as a business.
- Continuity of the organization: Since the owner is essentially what constitutes the business, if he or she were to die, the business itself would dissolve. Business activities cannot be continued by anyone after the sole proprietor passes away.
- Control: One of the key benefits to a sole proprietorship is the amount of control the single owner has over the company. This control extends to everything from to day-to-day activities like choosing when to work, to long-term decisions, such as how money will be spent. The sole proprietor makes all the final decisions and has ultimate say in every aspect of how the business is run. The owner has complete control, but cannot grant control to others to share in a profit unless he or she wants to convert the business into a general partnership or another form of business.
- Profit retention: In a sole proprietorship, the profits flow directly through to the individual owner, who keeps one hundred percent. Since the owner and the sole proprietorship are one and the same, the company's profits or losses are the individual's profits or losses as well.
- Expansion: When moving to another state, a sole proprietorship will need to be registered in the new state. If the name is already taken in that new state, a DBA must be filed. A separate legal entity does not need to be created since the existing entity can simply be transferred. Depending on the state that the business is moved to, the income tax could be higher or lower. The individual who owns the sole proprietorship will pay income taxes as a single unit, as mentioned above. Therefore, whatever the income taxes are for that specific state, the sole proprietor will owe the corresponding amount.
- Liability: A general partnership has the unfortunate disadvantage of unlimited liability for each member of the partnership. This means that creditors can come after both the business assets, as well as each member's personal assets. Any debts not satisfied by the business' assets or the personal assets of each member can affect the future earning power of each partner. Since each member is responsible for the other members' actions and financial decisions, a general partnership can be very risky.
- Income taxes: Similar to sole proprietorships, general partnerships are not required to pay federal income tax. The partnership does need to file an information return, but because the business is a pass-through entity, each member pays individual income tax on earnings. Members are required to file personal state income taxes individually, which vary from state to state.
- Continuity of the organization: Because a general partnership is comprised of two or more individuals, if one member leaves the company or dies, the partnership is dissolved. This can be avoided if an ownership transfer plan has been drawn up.
- Control: Each member of a general partnership has a predetermined percentage of control or say in major company decisions. Typically with two partners, that control is split 50/50. In the case of more than 2 partners, a 2/3 vote must be achieved for major decisions. Small day-to-day decisions can be made by each member on behalf of the business. New partners cannot be brought in unless all current general partners agree.
- Profit retention: All profits from a general partnership are split equally between the members unless stated otherwise in the articles of partnership. There are no shareholders in a general partnership, so profits are able to flow through to each member. Those funds can be either reinvested into the company, or kept by the individuals as personal income.
- Expansion: When a general partnership moves to another state, it is able to share the ease of transfer that a sole proprietorship enjoys. The partnership simply needs to be registered in the new state, and potentially file a DBA if necessary. There can be advantages to how state taxes are filed for the individuals when considering tax rates for different states. No separate entities need to be created for a general partnership to move or expand into other states.
- Liability: In a limited partnership, the limited partner and the general partner are treated differently in terms of liability. The general partner is unlimitedly liable, and can lose business assets in addition to the member's personal assets. Future earning power by the general partner can be affected if outstanding balances are due to creditors or other persons. In contrast, a limited partner enjoys limited liability where only his or her capital investment is at risk. Personal assets of a limited partner cannot be touched due to any transactions or debts of the business.
- Income taxes: Income taxes for a limited partnership are treated the same as a general partnership with regard to the income flowing through each member. General members are allowed to deduct business expenses and losses from their income, and subsequently pay tax on the remaining portion. Limited partners can't deduct any losses from their income, and must claim their portion of the income paid to them on their personal taxes. The limited partnership as a whole is not taxed federally, but it must file an information return. Then each member files separate and individual income taxes.
- Continuity of the organization: If a general partner dies or leaves the business without having preset an ownership transfer plan, the business is forced to dissolve. However, if a limited partner dies or leaves the business, the business can continue. A personal representative of the limited partner is entitled to the deceased's portion of the assets and deferred profit.
- Control: General partners have control on all decisions made regarding the company. Since the limited partner enjoys limited liability, he or she is not allowed to participate in the day-to-day transactions, or practice any control over business decisions. The general partners cannot grant any control to the limited partner, nor can they bring in any new partners without consent of all current general partners.
- Profit retention: Profits are distributed between the limited and general partnerships equally, or by a predetermined percentage for each different partner. The profits are passed-through to each individual, regardless of whether they are a limited or general member. Similar to a general partnership, partners in a limited partnership decide whether they will keep the personal income, or reinvest any amount into the business.
- Expansion: Expansion for a limited partnership is essentially the same as for a general partnership. When a limited partnership moves to another state, it simply needs to be registered in the new state, and potentially file a DBA if necessary. There can be advantages to how state taxes are filed for the individuals when considering tax rates for different states. No separate entities need to be created for a limited partnership to move or expand into other states.
- Liability: One of the benefits of a C corporation is the limited liability an entity has. The stockholders can only lose as much as they invested when purchasing stock. The board of directors as well as the officers are all technically employees of the C corporation, and therefore cannot be sued themselves (as long as they are operating legally). Their personal assets are untouchable to creditors unless they sign a personal note when receiving a loan for the business. In many cases, banks require the owners to carry active life insurance policies to ensure the ability to recover their investment in the case of a death. The entity itself is able to be sued, but those who own the business can only lose as much as they have personally invested. The future earning power of the individuals who comprise the business is not at stake with this type of business.
- Income taxes: C corporations have the disadvantage of paying taxes twice. First, the business as a whole pays taxes on profits, and then owners pay personal income taxes on dividends. Many states and municipalities employ a corporate income tax.
- Continuity of the organization: Because a corporation is its own legal entity, it is not affected when any member leaves the business for any variety of reasons. Although the business would be impacted with the loss of key players and their contributions, the company would still exist and be fully functional in the eyes of the law. Stockholders are free to share their portion of ownership at will. This is typically not an issue with publicly traded corporations, but can become an unfavorable situation for an individual who owns stock in a closely held C corporation.
- Control: In publicly traded corporations, the stockholders have limited control and are in charge of electing a board of directors. The individuals who make up the board of directors are powerless on their own, and can only act as a group. One job of the board of directors is to elect the officers of the corporation. The officers are those who ultimately have the most control in day-to-day activities and major decisions. The board of directors has ultimate control over the important decisions that need to be made and can choose to vote out an officer without cause. In closely held corporations, the roles are not always as structured. Oftentimes, the owners will fulfill multiple duties, including treasurer, vice president, and director. Typically each of the owners has equal control and power in day-to-day management.
- Profit retention: The profits that publicly traded C corporations earn are paid to stockholders in the form of dividends, if applicable. The amount of the dividend is predetermined in the articles of incorporation. In the event of a liquidation of a publicly traded corporation where there is both common stock and preferred stock, those with the latter are entitled to a return on their stock investment before those with common stock are given anything. With closely held corporations, they are more likely to increase the salaries of the owners to avoid paying as much of a tax on the business' profits, rather than divvy up the profits in the form of dividends.
- Expansion: Unlike sole proprietorships and partnerships, corporations are trickier to move their locations or expand the business. There are several options for a C corporation who would like to move to another state. On option is for the business to continue the corporation in the current state, and then register as a foreign corporation in the new state. With this option, there are more fees in both states, and additional paperwork to be considered. Another option is for a C corporation to choose to dissolve the corporation in the current state and establish a new one in the state it is moving to. Such a decision can impact employee benefits and incur tax consequences. The third option is for a C corporation is to merge the existing and new corporation into one. The new corporation will need to be registered in the new state. This option allows for the company to avoid paying fees in two separate states. Depending on the state, the taxes could be lower or higher. Some states, namely Delaware, are more beneficial for corporations to operate out of because of their reputation that is favorable to corporations. There are many corporate tax-friendly states which also may prove to be beneficial for businesses to reside in.
- Liability: The liability for S corporations and C corporations is essentially the same. S corporations enjoy limited liability, with each shareholder only liable to lose as much as they have invested. Any personal assets of the shareholders in an S corporation cannot be touched by creditors as long as business is conducted legally. The future earning power of the owner(s) is not affected beyond the current business because of this limited liability. Business assets, however, can be subject to claims against the company.
- Income taxes: S corporations are different from C corporations because they are taxed the same way that partnerships are. This way, they avoid the double taxation that C corporations unfortunately experience. S corporations are pass-through entities, and all the taxable income ends up going to the shareholders, who pay individual income tax. Business expenses can be deducted from the income claimed on taxes for S corporations, similar to C corporations.
- Continuity of the organization: One benefit to forming an S corporation is that the company is its own entity. This means that even if the owner(s) die, the company can continue. The shares can be transferred with an appropriate endorsement in an S corporation, unlike a partnership.
- Control: If one person holds one hundred percent of the shares, that owner has ultimate control over important decisions. The owner would be able to grand control to whomever he or she wishes. If there is more than one owner, the control would be split between shareholders according to the articles of incorporation.
- Profit retention: All profits are distributed in a pass-through form, where each shareholder receives a certain predetermined share. Because S corporations are privately held, they are able to decide how much of the profits are distributed toward each shareholder and how much should be reinvested.
- Expansion: S corporations are a special form of corporations that are mostly different for tax purposes. Because of this, an S corporation that chooses to move or expand to another state would need to check what the new state's tax laws are regarding S corporations. Some states do not acknowledge this business type and simply apply the same taxes as C corporations. S corporations will need to follow the same procedure as listed above for C corporations.
LIMITED LIABILITY COMPANY
- Liability: A key benefit for LLCs is the limited liability that each member enjoys. The owners are sheltered from the actions of the other members, and are only responsible for their own neglect. Each member of the LLC is not liable for the debts or liabilities that belong to the LLC. The future earning power of the owner(s) is unaffected by the LLC's failure or success, as each member is a separate and individual entity from the business. Personal assets of each owner cannot be touched due to debts occurring with the LLC.
- Income taxes: LLCs can be taxed as corporations, partnerships or sole proprietorships, depending on how the business operates in the eyes of the IRS. If the LLC has only one owner, it can be taxed the same as a sole proprietorship, or as a corporation. Similarly, if the LLC has multiple owners, it can choose to be taxed as a partnership or a corporation. If a business is currently an S corporation or a partnership, they can become an LLC without any additional tax obligations. However, if the business is a C corporation wishing to convert to an LLC, there may be several federal tax implications for the company.
- Continuity of the organization: A disadvantage associated with an LLC is the dissolution of the company with the exit of an owner. The dissolution can be caused from death, or an owner leaving the company. In some cases, owners can vote to continue the LLC. Ownership in the LLC cannot be transferred to others unless every member of the business agrees on the decision.
- Control: If an LLC has one owner, that individual would have complete control over the business, similar to a sole proprietorship. If the LLC is comprised of more than one member, the operating agreement would decide who can make important decisions or practice control over the company. This would typically be split between members equally, but it doesn't have to be.
- Profit retention: In LLCs, profits are passed-through to owners, like in partnerships. There are no dividends paid to shareholders with this type of company. The profits are not double taxed, and all the profits are allocated to each member based on the agreed upon amount. Profits and losses are shared by the owners in respect to their original investments.
- Expansion: If an LLC wishes to move to another state or expand, they must first file for domestication in the new state. After they have done this, if the company wants to continue doing business in the old state, they will need to register as a foreign LLC. Alternatively, the LLC can choose to be liquidated in the old state and simply form a new LLC in the new state. Another option for an expanding or moving LLC would be to register a new LLC in the new state and either have members transfer their membership interest, or merge the previous LLC with the new one. State taxes vary from state to state, but typically owners of an LLC pay personal state income taxes since the business is considered a pass-through entity.
*Disclaimer: This post is not to be taken as legal or professional advice. Please consult with your tax professional before starting your business.
So now that you know what the different types of business entities are, which one will you choose?