CHOOSING AN ENTITY
When you first explore starting your own business one of the first decisions you are going to make is the type of entity structure for your business. An entity structure is the legal structure of your business for legal, accounting, and tax purposes. It is usually one of the first steps in starting your business and in some cases the most over looked. There are many entities in which to choose from. The most common entities include the sole proprietorship, partnership, limited liability company, corporation, and S-corporation. As with any decision it is important to be educated on what is the best course of action and choosing an entity is no different. The following is a summary of the common entity structures including their advantages and disadvantages.
Sole Proprietorship
A sole proprietorship is an entity that is composed of a single person. The person owns all of the assets and liabilities of the entity and all income and expenses are to be reported and assigned to that person.
- Advantages: Ease of formation, simplified accounting, low administration costs
- Disadvantages: Potentially higher taxes, personal liability exposure
Partnership
A partnership is an entity that is composed of two or more persons. The partners own all assets and liabilities based on a predetermined allocation percentage usually based on how much each partner contributed to the partnership. The two more common partnerships are the general partnership and the limited partnership. The primary difference between the two is that in a general partnership the partners do not have much personal liability protection whereas in a limited partnership the partner personal assets are protected from liability. For tax purposes the partnership must file its own tax return but there is no partnership tax. Instead all of the income from the partnership “flows” to each partner’s respective tax return and is taxed accordingly.
- Advantages: Ease of formation, can combine more capital through multiple partners, low administration costs
- Disadvantages: Potential personal liability exposure, potentially higher taxes
Limited Liability Company
A limited liability company is essentially a partnership that that has the legal protection of a corporation. Because of this legal protection the partner’s personal assets are protected from any creditor claims. In a LLC the partners are called members and there can be an unlimited number. A LLC also has to file its own tax return and just like a partnership the income flows to the member’s tax returns and is taxed on the member’s individual tax returns.
- Advantages: Ease of formation, can combine more capital through multiple partners, legal liability protection
- Disadvantages: More structured accounting, higher administration costs, potentially higher taxes
C-Corporation
A C-Corporation is a separate legal entity owned by shareholders. C-Corporations have a completely separate tax system and the accounting is more tightly controlled. The lure of the C-Corporation is that shareholders personal assets are protected from any creditor claims. C-Corporations have to file a separate income tax return and pay a separate income tax.
- Advantages: Shareholder liability protection, can raise large amount of capital through multiple shareholders, corporate fringe benefits
- Disadvantages: Double taxation, higher administration costs
S-Corporation
S-Corporations are also separate legal entities owned by shareholders but the shareholders make an election with the Internal Revenue Service that gives the corporation a special tax status. The election that is made is called “S-Corporation election”. Essentially a corporation is a C-Corporation unless the S-Corporation election is made. For the S-Corporation election to be granted by the IRS there are a few requirements. Namely the S-Corp. cannot have more than 100 shareholders and can issue only one class of stock. The S-Corp. is not a separate taxable entity. Like a partnership all of the income flows from the S-Corporation to the shareholders individual tax returns. The lure of the S-Corporation is the potential tax savings. With the S-Corp. there is no double taxation because shareholders can take distributions from the S-Corp and distributions are not considered dividends.
- Advantages: Shareholder liability protection, potentially significant tax savings, no double taxation
- Disadvantages: High administration costs, very few fringe benefits, limits on amount of shareholder distributions