Did you know sole proprietorship is the most popular form of business entity? Did you know you can start with one and switch to another as your business grows?
Local attorneys will often refer new businesses to us in order to run their numbers and help them determine which business entity is the best to choose. Of the many choices you’ll have to make when starting a business, one of the most important is the business entity your company will be. Not only will this impact what you pay in taxes, it will affect the amount of paperwork your business has to do, the personal liability you’ll face, and your ability to raise money to grow your business. Each form has pros and cons. Here’s a quick look at the differences between the most common forms of business entities.
A sole proprietorship is the type most often chosen when it comes to business entity. It’s easy to begin and offers control to the owner. However, the owner is also personally liable for all financial obligations of the business.
A partnership involves two or more people who agree to share the profits or losses of a business. One advantage of this type of business entity is that the partnership does not bear the tax burden of profits or the benefit of losses—profits or losses are “passed through” to the partners to report on their individual income tax returns. A disadvantage is liability—each partner is personally liable for the financial obligations of the business.
A corporation is a legal entity created to carry out business. It becomes an entity apart from those who founded it that handles the responsibilities of the organization. Like a person, a corporation can be taxed and held liable in court for its actions. It can also make a profit. Perhaps the most desirable benefit of this type of legal structure is the avoidance of personal liability, but a big disadvantage is the cost of the business entity and the quantity of record-keeping required. Double taxation is occasionally identified as a drawback to incorporation, but the S—or Subchapter—corporation (a popular variation of the regular C corporation) avoids that by allowing income or losses to be passed through on individual tax returns, similar to a partnership.
A limited liability company or LLC, is a hybrid form of partnership gaining in popularity because it allows owners to take advantage of the benefits of both the corporation and partnership forms of business. Advantages of this type of business entity are that profits and losses can be passed to owners without the business itself being taxed, while the owners are shielded from personal liability.
Other Possibilities for Business Entity
Let’s take a look at your options, outlined on this chart:
|Comparison Factors||Sole Proprietorship (SP)||General Partnership (GP)||Limited Liability Company (LLC)||S Corporation (S Corp)||C Corporation – General Stock (C Corp)|
|Business formation||City tax license may be required.
No state filing required
|No state filing required. Some states allow GP’s to file at state agency. An Agreement between two or more parties. Partnership agreement should be created||Required to file formation document with the State filing agency. Most states require an Operating Agreement||Required to file formation document with the State filing agency. Most states require annual meetings and bylaws. Must elect S status through the IRS, additional filing required||Required to file formation document with the State filing agency. Most states require annual meetings and bylaws|
|Size||One person ownership||Two or more person ownership||Most states allow single-member LLC’s but some require 2 or more members||Up to 75 members/ shareholders||Unlimited|
|Length of Existence||Sole proprietorship either ceases doing business or dies||Depending upon partnership agreement. Typically death or withdrawal of a partner dissolves the GP||Some states allow LLC’s to have a perpetual existence. Others depend upon the state’s requirements||Perpetual||Perpetual|
|Liability||SP has unlimited liability and can lose personal assets||General Partners are equally liable or less the partnership agreement states otherwise||Members are not liable for debts accrued by the company or less a member secured the debt with a personal asset||Shareholders are typically not liable for the debts of the corporation. Some officers can be held liable if there is fraud or severe mismanagement.||Shareholders are typically not liable for the debts of the corporation. Some officers can be held liable if there is fraud or severe mismanagement|
|Operational Procedures||Easiest with few legal requirements||Typically GP’s have few legal requirements||Most states have some formal requirements like annual reports but are typically less than a corporation||Annual meetings, filings, and reporting required. Board of Directors and Officers must be maintained.||Annual meetings, filings, and reporting required. Board of Directors and Officers must be maintained|
|Start up cost||Cost of business tax license||Cost of business tax license||State filing fee is required.||State filing fee is required.||State filing fee is required.|
|Management||SP is in complete control of managing operations||Or less the partnership agreement states otherwise, each partner has equal management authority||Management is outlined in the LLC’s Operating Agreement.||Officers manage day to day corporate activities. Directors manage the officers and the overall company. Directors are elected and therefore managed by the shareholders||Officers manage day to day corporate activities. Directors manage the officers and the overall company. Directors are elected and therefore managed by the shareholders|
|Taxation||Taxed Once||Taxed Once||Taxed Once||Taxed Once||Double; both the corporation and shareholders are taxed|
|Pass through taxation for both income and loss||Yes||Yes||Yes||Yes||No|
|Interest Transferability||No. Or less business is sold to another party||No.||Depends upon the operating agreement||Yes. Some IRS regulations on stock ownership||Shares of stock are easily transferred|
|Raising Capital||Hard to get outside capital. Owner typically contributes all funds||Partners contribute capital and more capital can be raised by adding new partners||Some operating agreements allow interests to be sold||S Corps can sell stock to raise capital||C Corps can sell stock to raise capital|
|Dissolution||Easiest||Easy||Complex. Requires filing dissolution document with state filing agency. Some states require a tax clearance prior to dissolution.||Most Complex. Requires filing dissolution document with state filing agency. Some states require a tax clearance prior to dissolution.||Most Complex. Requires filing dissolution document with state filing agency. Some states require a tax clearance prior to dissolution.|
|Examples||Mom & Pop Ice cream shop||Land Developer||Real Estate Investment Property. Motion Picture. Any type of business depending upon specific state restrictions.||Small business or Family business such as a print shop, Pizza Parlor, or Interior Design.||Public Corporation. Software company, telecommunications company, etc.|
As mentioned at the start, sole proprietorship is the most popular choice for a business entity. This is perhaps because it’s so easy to begin making money, but it also exposes the owner to unlimited personal liability and precludes raising money from investors; the corporation and LLC provide limited liability protection. On the other hand, if you think that recognizing business profits and losses on your personal return is best for you, or if you wish to avoid double taxation, consider the S Corporation or LLC forms.
If you’d like help determining the right entity to save you money on your taxes, give us a call. No matter what you choose, you’ll want to meet with your financial planner, CPA, and lawyer to make sure things fall into place.