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Educate Yourself

Choosing Business Entity

by Robert Kowalski

Which Business Entity Is Right For Me?

Once decided to become involved in a new business venture, how would you know which legal entity is the right for you? The choice of entity would influence many aspects of the life of your business, from taxation to limiting liability, and more.

Let's start by reviewing the most common types of entities, available for people doing business in the United States:

Sole Proprietorship & General Partnership

A sole proprietorship is a type of business entity which is owned and run by one individual and where there is no legal distinction between the owner and the business. General Partnership is similar to Sole Proprietorship, except it is owned and run by two or more partners.

All profits and all losses accrue to the owner(s) (subject to taxation). All assets of the business are owned by the proprietor (or the general partners), and all debts of the business are debts of the owner(s) and must be paid from owner(s)' personal resources, meaning that the owner(s) has unlimited liability.

A sole proprietor may do business with a trade name (DBA) other than his or her legal name. This also allows the proprietor to open a business account with banking institutions. It is a 'sole' proprietorship in the sense that the owner has no partners. General Partnership usually does business under a trade name as well.

Establishing a sole proprietorship is cheap and relatively uncomplicated. You don't have to file any papers to set it up - you create a sole proprietorship just by going into business. In other words, if you'll be the only owner of the business you're starting; your business will automatically be a sole proprietorship, unless you incorporate it or organize it as an LLC. Of course, you do have to get the same business licenses and permits as any other company that goes into the same business. It is also advised to register a DBA ('Doing Business As') name with the state for your business.

General Partnership is established by drafting a partnership agreement and obtaining EIN for tax purposes. Registering a DBA is advisable in order to be able to legally operate under the chosen business name.

Advantages:
  • One takes all the profits of the business - no corporative taxes on the profits made,
  • No double taxation,
  • Easy to start up,
  • Relatively fewer regulation,
  • Full control over the business,
  • Easy to discontinue,
  • Quick decision process.
Disadvantages:
  • Unlimited liability - owner(s) of the business is (are) responsible for the business's debts,
  • If business becomes successful, the risks accompanying the business tend to grow,
  • Hard time raising capital - owner(s) have to make up for all the business's funds,

 

C Corporation

A corporation is a type of business entity that is organized under specific provisions of the General Corporation Law. A corporation must have shareholders, directors and corporate officers, and must be registered with the state. In addition, the corporation will be taxed at the state and Federal level on its earnings.

A corporation offers the protection from personal liability for the owners (shareholders). This 'corporate veil' of protection does not offer protection from liability in the case of fraud, failure to pay taxes, under capitalization of the corporation, or commingling of personal and corporate funds.

The "C" part of "C Corporaiton" refers to the designation of the corporation for tax purposes. Most major companies (and many smaller companies) are treated as C corporations for Federal income tax purposes. Keep in mind, since "C Corporaiton" is a tax designation, and not an entity type, some entities other than corporation (such as LLC) can elect to be taxed as "C Corporation". For corporations "C Corporation" is a default designation, and does not require any additional filings with the IRS or the state.

Advantages:
  • Limited Liability - owners of the business are not personally responsible for the business's debts,
  • A corporation may qualify as a C corporation without regard to any limit on the number of shareholders, foreign or domestic.
Disadvantages:
  • Double taxation - C Corporations are subject to corporate taxes, therefore creating the effect of double taxation (first on corporative level, and then on shareholders' personal level).

Click to learn more about C Corporations.

 

S Corporation

Similar to the C Corporation, S corporation offers all the benefits of a corporation, but with a different tax structure. S Corporations, much like sole proprietorships and partnerships, pay no corporate income tax. S corporation's shareholders report the company's income or losses on their personal tax returns.

To elect your corporation to be taxed as S Corp you need to file S Corporation election with IRS and some states.

One of the biggest differences of S Corp tax designation over disregarded entities and partnerships is in the way payroll and self employment taxes are paid, which could result in tax savings. Despite the obvious tax benefits, S Corporation comes with several restrictions. Major restrictions are:

  • Can't have more then 100 shareholders,
  • All shareholders must be physical persons - or simply put, real persons, not corporations, partnerships, etc (there are few exceptions for non-profits and trusts),
  • All shareholders must be U.S. citizens or residents,
  • Must have only one class of stock.

Click to learn more about S Corporations.

 

Limited Liability Company (LLC)

LLC combines the limited liability protection of a corporation (hence the name) with the flexibility and pass through taxation of a partnership/sole proprietorship. Like the shareholders of a corporation, the owners (members) of an LLC are not personally responsible for the debts or liabilities of the LLC.

The LLC has no limitations on who may be involved, and it can be managed by its members or by managers. It is often more flexible than a corporation and it is well-suited for companies with a single owner.

Advantages:
  • Limited Liability - owners of the business are not personally responsible for the business's debts;
  • No limits on number of members;
  • Flexibility in tax designation - LLC can be taxed as disregarded entity/partnership (default), or as S Corp or C corp (requires filing additional election documents with IRS and some states);
  • No double taxation, when elected to be taxed as disregarded entity/partnership, or S Corp.
Disadvantages:
  • In some states (e.g. New York, Illinois) more expensive to form and/or renew than corporation;
  • If your business is looking for major investment, your investors might be reluctant to invest in an LLC.

Click to learn more about Limited Liability Companies.

So Which Type of Entity Is Right For Me?

The answer to this question depends strictly on your specific needs and circumstances. We always recommend our clients to discuss your personal situation with a professional CPA or business attorney, however, it is equally important to educate yourself prior to scheduling appointments. After all, it is your business.

READ NEXT: LLC vs. Corporation »

DISCLAIMER REGARDING LEGAL ADVICE: This article is not intended to provide any tax advice or direction. None of information contained on this web site is intended to constitute legal or other professional advice, and you should not rely solely on the information contained on the site for making legal decisions. When necessary, you should consult with an attorney for specific advice tailored to your situation.

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