When you’re starting a business, the business structure or form of legal entity you choose is vitally important. You have a choice of several options. Each structure offers pros and cons which can be significant when analyzing them in the context of the goals you have for your business.
Give your decision careful thought. Your choice will impact your long- and short-term goals as well as your daily operations, exposure to liability, your taxes and the strategies available to you for growth. Getting it wrong can cost you dearly and IRS or other federal and state authorities could come calling. Even worse, you get sued because your entity doesn’t provide the protection you thought it did.
There are five common types of business entities. We’re providing some of the basics here and encourage you to use this information to formulate important questions and review them with your business attorney.
1. Sole Proprietorship
Description: A sole proprietorship is an unincorporated business owned exclusively by one person. Proprietorship costs vary, depending on your market. Generally, your early expenses will consist of state and federal fees, taxes, equipment needs, office space, banking fees, and any professional services with which your business needs to contract to assist with certain functions like technology, accounting, legal, and marketing. Some examples of these businesses are freelance writers, tutors, bookkeepers, cleaning service providers and babysitters.
Advantages: There is no legal separation between the business owner and the entity. They are one and the same which makes the sole proprietorship the easiest entity to set up and the least expensive entity to operate. Though costs do vary depending on your state of residence, there are typically only a few fees associated with proprietorship: license fees and business taxes.
As a single entity, you may be eligible for certain deductions, like health insurance. Plus, an owner is not required to file a separate tax return as required with a corporation.
There is also minimal paperwork as you have no partners or executive boards to whom you must answer.
Exiting/terminating your business is as easy as launching it. You can dissolve your business at any time, closing your doors and discontinuing any promotion or advertising. No formal paperwork is required.
Disadvantages: Because there is no legal separation between the business owner and the entity, the owner is personally responsible for any liabilities or debts incurred by the business.
2. General Partnership
Description: A general partnership (GP) is an agreement between individuals (the general partners) who establish and run a business together. All general partners actively manage, operate and control the business. A partnership agreement is required to get started.
Advantages: A GP is more expensive in set-up costs than a sole proprietorship but easier and less costly to form than a corporation. Because you are going into business with another person, you can alleviate some of the financial burden of start-up costs.
As an owner, a partnership affords you pass-through taxation. This means you will include your share of profits and losses on your individual tax return. You are not liable for paying any additional taxes on the business. A fringe benefit: You are not faced with cumbersome corporate tax forms.
Disadvantages: Each general partner has unlimited personal responsibility on all business liability and debts. The partners are also liable for each other’s actions. From a day-to-day operational perspective, you also face the possibility of disagreement on best practices. This limits your decision-making latitude.
There are also two other forms of partnership: the limited partnership (LP) and limited liability partnership (LLP). These alleviate some of the drawbacks of a GP. Though sub-categories of the general partnership, the management and control of these structures differ from that of a general partnership and from each other.
Both, however, have the advantage of the same pass-through tax status as the general partnership.
Limited Partnership (LP):
In a Limited Partnership, at least one partner must be a general partner and be subject to unlimited personal liability. The other partners, however, can be limited partners who are not actively involved in management of the business. Their liability, therefore, is limited (e.g., they cannot lose more money than they put into the partnership).
Limited Liability Partnership (LLP)
With an LLP, there is no general partner. In this structure, all partners are permitted to be involved in the operation of the business and benefit from limited liability. Many professional service businesses (e.g., doctors, lawyers, accountants and wealth management firms) prefer forming as an LLP, because partners are not liable for negligence claims made against their partners. Also pooled resources improve both the financial wherewithal and the diversity of intellectual capital in these businesses.
3. Corporation (C-Corp)
Description: A C-corporation, or C-corp, is a company or group of people authorized to act as a single legal entity. Its owners and shareholders are taxed separately from the entity. C-corporations, the most prevalent category among corporations, are also subject to corporate income taxation.
Profits from the business are taxed at both a corporate and personal level, creating double taxation. C-corporations pay corporate taxes on earnings before distributing remaining amounts to the shareholders in the form of dividends. Individual shareholders are then subject to personal income taxes on the dividends they receive.
Although requirements vary across jurisdictions, C-corporations are required to submit state, income, payroll, unemployment, and disability taxes. In addition to registration and tax requirements, C-corps must establish a board of directors to oversee management and the operation of the entire corporation.
Benefits: C-corporations limit the personal liability of the directors, shareholders, employees, and officers. In this way, the legal obligations of the business cannot turn into a personal debt obligation for any individual associated with the company.
The C-corporation continues to exist as owners change and the management team is replaced. C-corps have no restrictions on who can hold shares (e.g., shares can be held by non-U.S. citizens), and shares are readily transferrable compared to other entities.
C-corps have well established legal precedents and the C-corporation structure has widespread acceptance by venture capitalists and other investors, well-positioning these structures for M&A activity and growth.
The ability to reinvest profits in the company at a lower corporate tax rate is an advantage.
Disadvantages: The corporation pays its shareholders dividends from its after-tax income. The shareholders then pay personal income taxes on the dividends. The oft-mentioned “double taxation” C-corporation characterization is a reference to this taxation methodology.
Certainly, a C-corp is more complex to operate than a sole proprietorship and any form of partnership, largely because a C-corporation must comply with operational and management formalities. For example, the entity must hold shareholder and director meetings, and proper notice must be given for the meetings. A Corporate Secretary must also record and maintain the minutes of the meetings. C-corps also tend to have stricter record-keeping requirements, than say, a Limited Liability Company.
4. S-Corporation S-Corp)
Description: An S-corporation gets its name because it is taxed under Subchapter S of the Internal Revenue Code. This makes it a “pass-through” entity for tax purposes and results in a lower tax liability.
Benefits: Much like sole proprietorships, partnerships and LLC’s, the S-corporation was designed for small businesses because it avoids the double taxation of the C-corporation and results in a lower tax liability than the C-corp which is taxed under Subchapter C of the Internal Revenue Code. At the same time, the S-corporation offers similar liability protections, ownership, and management advantages as does a C-Corporation.
Disadvantages: S-Corporations have strict qualification requirements. In order to be eligible to make an S-corporation election—and to continue to be an S-corporation—the entity must meet strict requirements on the number and type of shareholders and the types of shares of stock. These rules are imposed by federal tax law, and not state corporation law. For example, only individuals, certain estates and trusts, and certain tax-exempt organizations can be shareholders.
Also, there cannot be more than 100 shareholders, and there can only be one class of stock. Further, when a company elects to be an S-corporation, it must observe all the corporate formalities imposed by its home state’s corporation statutes.
S-Corps must comply with rigid profit and loss allocation rules.
It is important to have a good idea about your long-term goals are for the business, as an advantage of forming as an S-Corp may turn into a disadvantage in some situations. Despite the advantage of pass-through taxation and lower tax liability than a C-corporation, money is not allowed to be retained within the corporation. If you intend to accumulate money for expansion, this can work to your disadvantage. A C-corporation will likely be better because you can retain income within the corporation.
Restrictions on the number and type of shareholders can also limit growth potential. Venture capitalists are also not allowed to provide financing to an S-corporation.
5. Limited Liability Company (LLC)
Description: A limited liability company is a hybrid entity structure that combines the characteristics of a corporation with those of a partnership or sole proprietorship. In an LLC, the business’ owners are not personally liable for the company’s debts or liabilities. LLCs are relatively new entity types when compared to C-corporations and other business structures. From 1977 to 1997, all 50 states and the District of Columbia enacted LLC statutes. Because LLC’s are formed through state statutes, regulations surrounding them vary from state to state.
Benefits: A limited liability company is generally not subject to federal income tax at the entity-level unless the LLC elects to be taxed as a corporation.
Under an LLC, members are shielded from personal liability for the business’ debts if it cannot be proven that they acted in an illegal, unethical or irresponsible manner in carrying out the activities of the business.
Many states don’t restrict ownership. This means that anyone—individuals, corporations, foreigners and foreign entities, and even other LLCs—can be a member. What’s more, profits and losses do not have to be divided equally among members. Interestingly, there is no company size limitation in forming an LLC. An interesting fact: Anheuser-Busch Companies, a multinational brewing company and a leader in the U.S. beer industry is an LLC. (Note: some entities, including banks and insurance companies, cannot form LLCs.)
An LLC is easier to set up than a C-corporation and provides more flexibility and tax advantages. For tax purposes, an LLC is considered a “disregarded entity.” Profits and losses are passed through to its members, who claim them on their tax returns.
Disadvantages: One possible disadvantage of an LLC—surely a caveat—is that while LLC owners enjoy limited personal liability for many of their business transactions, this protection is not absolute. This drawback is not unique to LLCs, however—the same exceptions apply to corporations.
One of the most significant aspects of this occurs if an owner treats the LLC as an extension of his or her personal affairs, rather than as a separate legal entity. If owners don’t treat the LLC as a separate business, a court might decide that the LLC doesn’t really exist and find that its owners are really doing business as individuals who are personally liable for their actions. To keep this from happening, make sure you and your co-owners fund your LLC adequately, keep LLC and personal business separate, and create a formal operating agreement which gives credibility to your LLC’s separate existence.
Your business and your goals are unique and, as you can see from our business primer, there are many factors that you must take into consideration. Online DIY opportunities abound. It is likely, however, these online-based businesses will not provide the comprehensive guidance, documents and forms—the foundational breadth—you will need to operate and grow in a manner consistent with your vision.
These online businesses tend to shortcut general information and important provisions and provide only a limited number of cookie-cutter forms that fail to address important provisions that should be included in your entity’s governing documents.
Don't Be Fooled
While dollar-wise these offers may be tempting, don’t be lulled into a false sense of security. These sites cannot replace the knowledge and experience of your business attorney. Ironically, the online sites say as much in their fine-print disclaimers which also disclaim them from liability and your defense if you find out all too late that you’ve made a serious misstep.
Getting It Right
Having the right entity structure for your business can save you substantially in taxes, protect your personal assets, make your daily operations more efficient, and make you attractive for financing to fuel future growth.
At Garza Law, LLC, we know that setting up the right entity is critical to both the future of your business and the financial and legal protections you want and need in your personal life. We are committed to helping you establish an appropriate and strong foundation for your new business venture.
Call us at 208.557.8705 to make sure you get it right.