After you have made the exciting, daunting and life-changing decision to go into business for yourself, probably the most critical and complex decision impacting the potential success of your business immediately presents itself: What form or type of business entity should you create? Many people are not really sure of what their options are in this regard, let alone sure of the potential risks or rewards resulting from that decision.
The “Menu” and the “Why”
The best path to follow in facing this hurdle includes getting the advice of legal and financial professionals so that your decision can be a completely informed one. Another wise course is to take a few minutes to understand your options and how your selection may impact various aspects of your business. That is the purpose of this (and following) articles.
In this article, we will discuss the “menu” of available business entity types and what considerations generally govern this decision. In others, we will elaborate on the end results of this decision and some of the details as to how this will impact the operations of your company and financial results of your ownership. Remember, a complete understanding of these matters is not our goal and is beyond what you want to accomplish, given especially all of the hurdles you already face in starting your new business. However, a little general knowledge will help you immensely in understanding what your trusted advisors tell you and in ultimately making the selection.
Common for-profit, non-professional business entities
Professionals often are required to use special entities, such as professional corporations and limited partnerships.
The following list sets forth all of the available alternatives for “non-professional,” “for-profit” business organizations in the United States (“professionals” such as doctors and lawyers must use special business entities with different liability and even tax consequences beyond the scope of this article):
- Sole Proprietorship – must be owned by one person or a married couple. If there are more than one owners, the business automatically becomes a General Partnership unless some other type of entity is created.
- General Partnership – must be owned by two or more persons or two or more of the other types of entities. A partnership, limited liability company or corporation may generally, but not always, be a partner unless a Partnership Agreement or some applicable law or regulation states otherwise. If you’re considering joining an existing partnership, you might find our previous article, Tips for Successfully Joining a Partnership, helpful.
- Limited Partnership – same as a General Partnership except for formation, liability, operational, and tax differences. Owners may be “General Partners” of “Limited Partners.”
- Limited Liability Company (or LLC) – may be owned by one or more persons or other entities. Owners are called “Members.”
- Corporation – may be owned by one or more persons or entities, called “stockholders” or “shareholders.” From a tax standpoint, may be a “Subchapter C” corporation or a “Subchapter S” corporation.
Except for federal tax treatment of these entities and depending upon the industry, most of the other aspects and issues in their formation, legal effect and conduct are governed by state law. State laws will vary, creating perhaps the biggest reason to seek the help of a professional. For additional research materials, consider checking in with the IRS’ Business Structures guide and the Small Business Administration’s (SBA’s) outstanding Business Types starting page.
Fore more information on tax issues, at least for a C Corporation, please read Return of the C-Corporation, which addresses the Tax Cuts and Jobs Act of 2017, which significantly altered how companies are taxed. This has created some incentive to consider C-Corporations over LLC’s.
Many factors control which type of business entity you should choose
Consider consulting with a professional or attorney to help you decide.
Which one of these types of entities suits your needs as a business enterprise depends upon many factors. All of these areas must be considered and priorities established in order to assure that your business needs are met. Following is a brief summary of some of these important issues:
- The complexity of formation of the entity and the complexity of keeping the entity compliant with laws and regulations – a sole proprietorship or even a general partnership may be formed without any formal documents (although this may not be advisable – read our previous article entitled, Not Incorporating is Risky Business). Accounting, reporting and the preparation and filing of tax returns may be significantly simpler or more complex depending on the form of business used.
- The number of owners and their level of involvement – as described above, certain entity types are available only to single or multiple owners. Also, in some cases certain owners may wish to be “passive” investors and to have limited authority, responsibility and liability.
- What “type” of owners are allowed; i.e. whether the owners must be individuals or may be other business entities.
- Liability to customers, vendors and other third parties – some of the listed types of entities provide a limitation of liability to owners and prevent unlimited access to personal assets of the owners by creditors.
- The ability to attract capital and the capital structure of the business – the number of investors and the extent to which your business is capitalized by equity (ownership) investment versus debt (lending) will be an important consideration in your choice of entity. Either debt or equity third-party investors may demand certain legal or tax treatment before they are willing to invest.
- The industry in which you are engaged – some, generally heavily regulated, industries mandate that the business operate as certain types of entities. Examples are banks, liquor establishments or various types of franchise operations.
- Business management preferences – do you intend for all owners to have a say or vote in business operations or do you want to limit or even prevent management participation by some owners? Will the business be managed by non-owners? The answers to these questions may impact your entity choice.
- Tax considerations – perhaps the most crucial and most complex area of analysis when it comes to entity choice. Each of the types of entities described may bring substantially different tax results to the same transaction or occurrence. These potential differences arise in various areas including the nature, timing, amount or recognition of income or loss; the deductibility of expenses; allowable accounting methods; the retention of earnings in order to meet future operational requirements; the tax rate applied; the possibility of double taxation; the availability and tax treatment of fringe benefits such as pension or, health and life insurance; the application of payroll taxes or the self-employment tax; and the amounts, methods and tax treatment of compensation of owners. These differences may occur at both the federal and state level. We discuss some of this in detail in our previous article, Not Incorporating is Risky Business.
- The ease of transferring ownership and the tax consequences of such transfers to third-party purchasers or heirs.
This is just a partial list of the various factors that need to be carefully analyzed. The details behind these differences are complex and a complete understanding requires specialized study or training. We will discuss some of these matters in more detail in future articles. In the meantime, it is important that you understand that unless you are a legal and financial professional, you should not attempt to make these decisions without consulting one (or more).
Law 4 Small Business (L4SB). A little law now can save a lot later.
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