Choice of Entity for New Business

08/03/2010

For people who decide to start a business, one of the first questions they need to answer is what type entity will they use to operate the business.  There are a number of choices – sole proprietorships, limited liability companies, partnerships and S Corporations and C Corporations.

Given the number of choices available for structuring a business entity, the question is often asked which is the best form to use.  Unfortunately, there is not a one size fits all answer.  Still there are some general rules to follow.

Limited liability companies (“LLC”) and corporations are separate legal entities.  In other words, a corporation or an LLC will be treated as if it is someone other than you.  This is not the case with a sole proprietorship.  This distinction is important for many reasons.  For example, if your business form is a separate legal entity, it can own property, enter into contracts, and hire employees, without generally exposing your personal assets to the liabilities of the business.  Additionally, a corporation or an LLC will create a management structure that makes it possible for multiple people to own and operate a business with a clearly-defined set of rules regarding decision making.  With a sole proprietorship, there is by definition only one owner.  With a partnership, there are multiple owners, but the management structure is often looser then with a corporation or an LLC.

When most people look toward the best structure to fit their business, they typically concentrate on tax issues, liability issues and control issues.

Taxes

A corporation has two choices when it comes to taxes.  It can be taxed as a C Corp, which means that the corporation is a taxpayer and income is taxed at the corporate level, and again at the individual level when owners are paid a salary or dividends.  This is the “double-tax” issue that you often hear about.  Proper planning with a privately owned C Corporation could generally avoid double taxation for normal day to day operations.  However, if you want to do away with double taxation altogether, you can elect to be taxed as an S Corp.  By choosing S Corporation status, you have to limit in a number of areas.  First, you can only have a set amount of owners.  Second, you cannot have multiple classes of stock (like common and preferred).  If a corporation elects S status, that means that all income would pass through to the owners and taxed directly on the owners’ tax returns.

An LLC can be taxed as a corporation or a partnership.  In other words, the IRS makes you select some other entity type and have your LLC taxed that way instead.  For example, you can generally choose to have your LLC taxed as a C Corporation, an S Corporation, a partnership, or a sole proprietorship.  If you need to elect partnership taxation, but don’t want to face the liability of a partnership, or if you want to be taxed as an S Corporation, but can’t qualify, you probably should consider an LLC.

If you are a sole proprietor, all income, deductions and expenses are reported on Schedule C of your Individual Income Tax Return (Form 1040).  This is relatively simple, but a sole proprietorship does not provide asset protection.

Liability

From a liability standpoint, a corporation and LLC are similar, although the LLC has a couple of benefits.  Basically, as long as you observe the required formalities – i.e. meetings, record-keeping, avoid using business funds to pay your personal expenses, etc. – then a corporation or an LLC will both protect your personal assets from business debts or lawsuits.  The key difference is that an LLC has simpler requirements.  In other words, it’s harder to blow the formalities and expose your personal assets.  That’s a benefit for small business owners who already have enough on their mind in addition to having to worry about holding formal meetings and the like.  There is another area of liability protection that an LLC offers.  If you get sued personally and a plaintiff gets a judgment against you, it’s generally easier for that plaintiff to seize your business shares and take a corporation from you than it is for a plaintiff to take your LLC membership interest.

From a liability perspective a sole proprietorship and a general partnership do not offer asset protection.  In other words, an owner’s personal assets are exposed if there is business liability.

Control

Corporations are owned by shareholders, who then elect directors, who then appoint officers.  The day-to-day power belongs to the officers.  If the directors don’t like the officers’ decisions, they can replace them.  And, if the shareholders don’t like the directors’ decisions, then they have to remove them.  

With a LLC, the company is run directly by the owners – who are called “members.” It is possible to make the LLC run by one or more “managers,” which provides for a little more centralization of control if there are multiple owners.

The Choice of Entity

There are a lot of factors that affect a choice of entity decision.  This blog is really just an oversimplification of the basic thought process.  But the choice is very important.   You are starting the business that will provide you income and, hopefully, provide the wealth that allows you to retire.  This is your life.  If you are considering starting a business, we would be happy to assist you in choosing the right type of entity that makes sense for you.