Choosing an entity is often the first major legal decision an entrepreneur must make. In recent years the options have increased. An individual business owner may have a sole proprietorship, a corporation (C or S), or a limited liability company. An organization with multiple owners can be formed as a general partnership, corporation, or limited liability company (“LLC”) (note that limited partnerships and limited liability partnerships will not be discussed in this article). On what basis does a company make this important decision? Certain key factors help form a guide to answering this question.
Single owner
This is the easiest, least expensive, and least regulated type of organization for the individual. The only legal necessity to form this business is to start operations. It is recommended that you file a fictitious name registration in all states in which the business will operate and check the zoning and licensing laws for the business location. Additionally, all marketing materials must be trademarked and/or copyrighted.
As a result of the simplicity and low costs involved in a sole proprietorship, many sole proprietorships choose this option. However, there are some negatives to consider. The most important reason for choosing one of the other options is that the person is fully responsible for any and all claims by customers, employees, vendors, or others.
General Society
Similar to the sole proprietorship at the facility of formation, the only requirement to form a general partnership is that two or more persons engage in a for-profit business activity (Uniform Partnership Act). Expenses and profits do not need to be shared equally. While there are no formal requirements, it is strongly recommended that a written partnership agreement be signed between the partners. Like a sole proprietorship, the general partnership is not taxed as an “entity.”
There are downsides to a general partnership. Partners in a general partnership have unlimited personal liability not only for their own torts and contracts, but also for those of the other partners. The death or separation of one of the partners causes the dissolution of the general partnership. Caution should be taken to prevent the IRS from considering the partnership as a corporation and then being taxed as such.
Corporation
A corporation that is owned by a limited number of people is known as a “closely held corporation.” Like a corporation, most, if not all, of the shareholders are involved in running the business. Unlike a partnership, however, all shareholders or owners of the corporation have limited liability for the acts and omissions of the other owners. Also, avoiding personal liability for business debts and court judgments is another advantage of a corporation. Generally speaking, a creditor can only collect against the company’s assets, not against the personal assets of the owners.
Because a corporation is a separate legal entity from its specific shareholders, business continues regardless of who owns the shares. Corporations offer the opportunity to attract investors who can own shares in the company without having to worry about personal liability. Tax deductions can be taken for benefits provided to your employees and owners. Corporations often have a more favorable tax rate structure to allow owners to save profit at a lower rate.
There are two types of for-profit corporations, the “C” corporation and the “S” corporation. These refer to IRS statutes that dictate different tax treatment for the two types of entities. A “C” corporation is required to pay corporate taxes on profits and shareholders pay taxes on their compensation and/or dividends. For this reason, many small organizations choose to be “S” corporations. An “S” corporation pays no income tax; profits and losses are passed on to the owners. However, the owners of an “S” corporation cannot be corporations, partnerships or LLCs.
Some of the disadvantages of forming a corporation are the costs and paperwork involved. Incorporation costs vary by location, but typically run to several hundred dollars. Corporations are required to hold annual board and shareholder meetings, and minutes of the actions of directors and shareholders must be kept.
limited liability company
The LLC is a relatively new entity. It was created to combine some of the advantages of a general partnership and a corporation while eliminating some of the disadvantages of both. The owners of an LLC, called “members,” have limited liability similar to that of shareholders in a corporation. However, in structure, the LLC is more like a partnership.
The LLC can be managed by the members or by a manager. Usually there is no board of directors or officers. Corporate formalities such as meetings and minutes are not required. Gains and losses are passed through to the owners on their personal tax returns and are not taxed separately to the entity. LLC members do not have to be individuals and the voting power and profit and loss share do not have to be identical; For example, an owner may receive X% of the profits and own Y% of the LLC and have Z% of the voting rights. It’s obvious to see why LLCs are so popular.
In conclusion, there are many factors to consider when choosing the entity form for your business. The advice of your accountant or tax adviser and lawyer should be considered before making a selection. We welcome any questions you may have.
THIS ARTICLE IS NOT INTENDED TO PROVIDE LEGAL ADVICE OR TO ESTABLISH AN ATTORNEY-CLIENT RELATIONSHIP.