How to choose an entity type

Introduction

Starting and running a business can be a challenging thing to do. There are many difficult decisions that must be made for the business to thrive and provide the living that you need and to provide your customers with the products and services they need. One of the most important choices you will need to make as a business owner is what type of entity you want to use for your business.

Business entity types to choose from

There are many different types of business that could be right for you. Here are some of the most common examples.

Sole Proprietorship

This is the most common form used by most business owners when the first begin their business. There are not enough resources and infrastructure needed to justify having a corporation at first for many people. A sole proprietorship is fairly simple. It consists of only one person who is the sole proprietor or owner of the business and all the income and liabilities associated with it. The income that comes from the business is taxed as if it were just personal income of the person themselves. Many people choose this type of business because there are many less formalities associated with forming it than other types of entities. Income from this type of business is filed on the normal 1040 income tax form under a schedule C form. Self employment taxes, like the employer portion of FICA taxes, must be paid on the income from a sole proprietorship in addition to the normal income taxes.

One of the difficulties with a sole proprietorship is that the owner of the business is liable for all the debts incurred by the business. If a sole proprietor acquires a loan for machinery or has a lease on an office and the business cannot pay for them, the owner is still personally responsible. The reverse it true as well. If the owner is sued because of an accident or any other reason, the assets of the company are also considered personal assets and could be included in the lawsuit. This is the one major disadvantage that leads many business owners to change types of business as soon as it can be justified financially and logistically.

Partnership or General Partnership

In a partnership or general partnership there is more than one owner of the business. The partner can both be active in the business or silent and just provide funding and other resources. Again the business does not pay taxes on the income earned, but rather it is paid by the owners of the business as personal income tax. The partnership owners can be either be people or other legal entities. There are always at least two partners and sometimes many more depending on the business and the services offered. There is really no formal organization as a business entity like a corporation with a general partnership. There may be written documents outlining the obligations of each partner within the business and they could include statements of liability, assets, income or loss, and rightful control of business operations. Partners in each organization are liable jointly and severally liable for all partnership debts. This means that each partner can be held responsible for the entire partnership debt. Each partner also has the ability to hold the other partners liable for any actions that are taken in connection against the partnership. Of course there are limitations that can be placed on these responsibilities and liabilities but caution should be used when choosing partners and you should be aware of the potential danger of a partnership.

Partnerships are formed by filing a certificate of limited partnership with the appropriate state and local offices, normally the secretary of state.

Limited Partnership

In sole proprietorships and partnerships, the owners of the business are all active participants in the daily activities of the business. In a limited partnership, there are general partners who make sure the business if run from day to day and limited partners who may participate in the business but are not liable for partnership debts. Limited partners are passive investors in the business. All limited partnerships are required by law to have written partnership agreements.

Limited partners are limited in the amount of their risk to the amount of their investment in the company. They cannot lose more than they have put in. Limited partners do not pay self-employment taxes on the income earned through the business.

Corporation

Corporations are another very common form of business and can range from just a few people to thousands of employees. There is also an unlimited number of shareholders or stockholders that own the business. Forming a corporation is much more complicated than forming the other types of businesses discussed above. There are of certain benefits and disadvantages and it is important to evaluate them for each business and situation. The use of a corporation may or may not be justified for each business. There is a lot more paperwork and other formalities that must be observed when forming a corporation. There are two basic types of corporations - C and S corporations and they default to a C corporation if the deadline is not reached to make it an S corporation. S corporations are taxed like partnerships, meaning there is no taxation for the business entity itself but the taxes are paid by the employees and shareholders on their personal taxes.

One of the main reasons business owners will start a corporation or transition an existing business to one is for liability reasons. In all corporations, owners or members are only liable for their investment in the business and nothing more. Corporations almost always have more employees than a partnership.

S versus C Corporation

S corporations are normally limited in the number of shareholders and are generally more suitable for smaller companies. There are normally less than 100 and they pay no corporate taxes on income. Both types of corporations appoint or elect a board of directors that oversee the sane operation of the business. S and C corporations are held by the same organizational guidelines and have to file similar paperwork at formation.

Most large businesses are C corporations because they need the liability protection that is offered by a C corporation. Some large businesses cannot qualify for any other form of business strictly because of their size. One of the disadvantages of C corporations is that the business is taxed on income and the employees are taxed on income as well. Some people refer to this as double taxation.

LLC (Limited Liability Corporation)

An increasingly popular form of business entity is the LLC or limited liability corporation. In some states only one person is required to begin and LLC. LLCs have many advantages over S and C corporations again relating to taxation and liability. The name of the entity comes from the fact that the owner is limited in their liability for business affairs. One of the main reasons that some business owners will form LLCs is that they are not subject to the double taxation of corporations and they are also accorded the personal asset protection should anything happen to the business. There is also less expense and formality associated with forming an LLC than an S or C corporation. This is a huge benefit to many business owners because the size of their business may not warrant the increase bureaucracy assumed by forming a corporation.

Criteria to evaluate

There are several things that you should evaluate when you are deciding which entity type is best for you. First you should determine how important legal liability is to you. If you want to protect your assets and assure that you are not liable for the mistakes of partners or other people, you may want to steer clear of sole proprietorships and partnerships. A general partnership or other form of corporation may be more suitable for your needs.

Tax implications are also very important to consider. Many people form LLCs or S corporations because they want to avoid the double taxation of C corporations while enjoying the liability protection provided by these forms as well.

The cost of formation and continued use is also a factor for many people. Corporations are much more expensive and require more annual reports and paperwork than do LLCs and partnerships.

Flexibility is also important. Some types of business will require more than others because of the market they participate in and the fluctuations that are associated with a particular type of industry.

And of course future needs should be evaluated when any decision is made. If it is likely that you will grow significantly in the next few years you may want to put off the changes or make them sooner to have the capital resources necessary to fund the operations of the business.

Conclusion

Perhaps the most important thing for you to remember is that the type of business entity that is right for you may be different from other people and businesses that you know. It is important to evaluate this decision strictly from a business standpoint and never from a desire to keep up with someone else or have the coolest type of business in town. The entity you choose should always fit your needs and ensure the success of you and your business.