Which Legal Entity Should I Choose For My Business?

With a check of the box, business owners can choose a tax structure with enormous financial repercussions both now and in the future. Or, they can find themselves in a situation where corporate formalities were not observed, thereby opening the door to personal liability. The choice of business entity is clearly very important. So, is there an easy answer to which entity would be best from a legal, tax, and business standpoint? Unfortunately, no. Which entity to select will depend on a plethora of factors, including the decision to issue securities, the desire to attract investment, the business’ management structure, estate planning goals, the number and type of employees, the forms of employee compensation, and the near and long term potential for profit and losses. In this article, we discuss three major points that business owners should touch upon when considering a choice of entity.

1. Two Levels of Taxation, or One?

First, business owners should consider what the effects will be of corporate level taxation. It is commonly stated that S Corporations, partnerships, and certain LLCs are superior to C Corporations because they offer “pass-through” tax treatment- i.e., one layer of tax. This is true in many cases: thanks to one layer of tax, shareholders or members of pass-through entities often pay much less tax than C Corporation shareholders.

Proponents of C Corporations often counter by citing the deductions which are available to the corporation for employee wages, or the current low rates of capital gains taxation available to shareholders. The tax structure could also be seen as an incentive to hold profits at the corporate level to support growth and re-investment. However, the IRS has tools to discourage the payment of unreasonably high wages for tax advantage in a C Corp, just as they have tools to discourage unreasonably high distributions in an S Corp. Also, there is no guarantee that long term capital gains rates will remain low. A C Corporation may be a superior entity for attracting investment, but the use of other entities early on in the business’ life should not be overlooked. Ultimately, it may be a loser’s game to try to manipulate the tax system to make a C Corp work when a different entity is more appropriate.

2. Do you Have the Time or the Temperament to Observe Corporate Formalities?

Second, business owners should consider how their business operates and what business structure would be the best fit for their particular needs. Constantly, small business owners are failing to observe corporate formalities by maintaining corporate minutes, resolutions, and other records. In some cases, this may be exposing owners of businesses to liability for litigants who seek to “pierce the corporate veil” and reach shareholders directly. In some cases, business owners are doing themselves an enormous favor by choosing a legal entity that requires minimal corporate formalities.

With an LLC, for instance, a business operating agreement can be customized to the business’ particular needs. It is a rare member-manager who wishes to maintain each and every corporate formality, and that’s not a problem with an LLC. The operating agreement may specify that certain records need not be kept. This can save owner-managers a lot of time and money in producing corporate records. It also can prevent veil piercing by litigants.

3. Money

Third, business owners also need to consider the money. Are there current profits or losses? If there are multiple owners, would one owner benefit from recognizing losses, while the other could stand to recognize more gain? What is the long term potential for profits and losses? These issues will heavily influence the ultimate choice of entity. With an LLC, for instance, members can recognize both pass through gains and losses. The operating agreement can also be customized to allocate gain to one member, and loss to another.

IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

General Disclosure: This article is intended to provide general information about business entity selection and should not be relied upon as a substitute for legal advice from a qualified attorney.

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Incorporation 101 – What Type of Legal Entity Should I Choose?

Which Business Entity Is Right For Me?

Once decided to become involved in a new business venture, how would you know which legal entity is the right for you? The choice of entity would influence many aspects of the life of your business, from taxation to liability limitation and more.

Let’s start by reviewing the most common types of entities, available for people doing business in the United States.

Sole Proprietorship

A sole proprietorship is a type of business entity which is owned and run by one individual and where there is no legal distinction between the owner and the business. All profits and all losses accrue to the owner (subject to taxation). All assets of the business are owned by the proprietor and all debts of the business are his debts and he must pay them from his personal resources, meaning that the owner has unlimited liability.

A sole proprietor may do business with a trade name other than his or her legal name. This also allows the proprietor to open a business account with banking institutions. It is a “sole” proprietorship in the sense that the owner has no partners.

Establishing a sole proprietorship is cheap and relatively uncomplicated. You don’t have to file any papers to set it up – you create a sole proprietorship just by going into business. In other words, if you’ll be the only owner of the business you’re starting; your business will automatically be a sole proprietorship, unless you incorporate it or organize it as an LLC. Of course, you do have to get the same business licenses and permits as any other company that goes into the same business. It is also advised to register a DBA (“Doing Business As”) name with the state for your business.

Advantages of Sole Proprietorship:

One takes all the profits of the business – no corporative taxes on the profits made,
No double taxation,
Easy to start up,
Relatively fewer regulation,
Full control over the business,
Easy to discontinue,
Quick decision process and no opposition when taking a decision.

Disadvantages of Sole Proprietorship:

Unlimited liability – owner of the business is responsible for the business’s debts,
If business becomes successful, the risks accompanying the business tend to grow,
Hard time raising capital – owner has to make up for all the business’s funds,
Sole proprietor is responsible for his or her own health insurance.

C Corporation

C Corporation is a type of business entity that is organized under specific provisions of the General Corporation Law. A Corporation must have corporate officers and bylaws, and must be registered with the State. In addition, the corporation will be taxed at the State and Federal level on its earnings.

A corporation offers the protection from personal liability for the owners. This “corporate veil” of protection does not offer protection from liability in the case of fraud, failure to pay taxes, under capitalization of the corporation, or commingling of personal and corporate funds.

Most major companies (and many smaller companies) are treated as C corporations for Federal income tax purposes.

Advantages of C-Corporation:

Limited Liability – owners of the business are not personally responsible for the business’s debts,
A corporation may qualify as a C corporation without regard to any limit on the number of shareholders, foreign or domestic.

Disadvantages of C-Corporation:

Double taxation – C Corporations are subject to corporate taxes, therefore creating the effect of double taxation (first on corporative level, and then on shareholders’ personal level).

S Corporation

Similar to the C Corporation, S corporation offers all the benefits of a corporation, but with a different tax structure. S Corporations pay no Federal income tax, but pay state level tax. S corporation’s shareholders report the company’s income or losses on their personal tax returns.

Despite the obvious tax benefits, S Corporation comes with several restrictions. Major restrictions are:

Can’t have more then 100 shareholders,
All shareholders must be physical entities – or simply put, real persons, not corporations, partnerships, etc (there are few exceptions for non-profits),
All shareholders must be U.S. citizens or residents,
Must have only one class of stock.

Limited Liability Company (LLC)

LLC combines the limited liability protection of a corporation (hence the name) with the flexibility and pass through taxation of a partnership/sole proprietorship. Like the shareholders of a corporation, the owners (members) of an LLC are not personally responsible for the debts or liabilities of the LLC.

The LLC has no limitations on who may be involved, and it can be managed by its members or by managers. It is often more flexible than a corporation and it is well-suited for companies with a single owner.

Advantages of LLC:

Limited Liability – owners of the business are not personally responsible for the business’s debts,
No double taxation,
No limits on number of members.

Disadvantages of LLC:

Usually more expensive to form and/or renew.

So Which Type of Entity Is Right For Me?

The answer to this question depends strictly on your specific needs and circumstances. We always recommend our clients to discuss those specifics with a professional CPA or business attorney, however, it is equally important to educate yourself prior to scheduling appointments. After all, it is your business.

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Learn the Differences Between Each Legal Business Entity Type

Your individual state will register your legal business entity, and it’s important to understand that not all states recognize every business entity type. The descriptions below are meant to give you a basic understanding of the differences between entities, but you should check with your local government to see which type of business designation is right for your new venture.

Sole Proprietorships

Most small businesses choose the legal business entity of a “sole proprietorship”, where one person is the only “owner” of the business. Legally, there is no difference between you and your business, and while this business entity type is preferred by some because of the ease in setting it up and registering it, there is a greater legal risk assumed by the owner of a sole proprietorship. For example, if someone sues your business for infringement or fraud, they will be suing you, and your personal assets will be on the line if the case is taken to court – a disadvantage to this kind of legal business entity. This type of situation is rare to be sure, but from a business standpoint, it has the potential to be a risky move.

An advantage of this entity is the fact that you’re the only owner! You can make your own business decisions without having to consider the opinions of a board of directors, or other stakeholders. You receive 100% of the income from your business, and are free to file your profit on your individual tax return at the end of the year – a huge advantage to choosing this legal business entity type.

Partnerships

As the name implies, a partnership is an entity in which two or more people own a business together. Just like a sole proprietorship, there is no legal difference between the owners / members of a partnership and the business itself. As previously stated, choosing this legal business entity can have potentially negative consequences if someone were to file a suit against you or your business. An entity type of this sort carries an additional risk because of the added element of another person. For example, let’s say your business partner did something illegal and the court has decided to penalize your business assets because of his or her mistake. Although you have done nothing wrong, the whole business may be at risk of going under because of the partnership liability. Again, although this is rare, it is important to consider when choosing this kind of legal business entity. Types of considerations like this can protect your investment in the long run.

Speaking of investment, an advantage to a partnership is the ability to raise more funds with the influence of more people. Instead of having to shoulder all of the capital upon startup yourself, a partnership can help business owners divide the cost of operational expenses. And of course, because you’re sharing costs, you and your partner(s) will have to share profits as well. A benefit of this kind of legal business entity is the financial ease achieved by being able to file your profits under your individual tax return at the end of the year.

When starting a partnership, it is important to draw up a legal agreement detailing how costs and profits will be shared, what to do in the event of a partner wanting to leave the business, how to settle disputes about business strategy, etc.

Corporations

Unlike sole proprietorships and partnerships, where the owners are legally the same as their business, corporations offer business owners a unique legal and tax benefit in the sense that corporations are granted their own legal status. Therefore, this business entity type is considered as a separate legal business entity from you, your partners, and your shareholders. If your business were to be sued, it would not put you or your personal assets at any risk. So wait…who are shareholders? Whereas you’re an owner / operator / member of your sole proprietorship or partnership, you become a shareholder in a corporation, because this type of business operates with stock, or partial ownership distributed amongst several people. As a shareholder, you “own” a part of the business, but you also have to routinely answer to a board of directors who steer the direction of the company.

The downside to the legal business entity of a corporation is that you have less individual freedom to make executive business decisions, and you are not in total ownership of your business. This business entity type is more difficult to begin and dissolve, and often must comply with a series of complex federal and state regulations and taxes. However, the obvious benefit to this type of legal business entity is that you have more individual legal protection with the separation of yourself from your business in the event of a lawsuit.

Limited Liability Company (LLC)

Finally, a Limited Liability Company (LLC) is a sort of combination of all of the above business structures. Like the “corporation” business entity type, an LLC offers a legal distinction between a person and their company, but like a sole proprietorship or partnership, it offers the owner or member (we’re back to being called members now) control over business decisions, tax breaks, and offers no stock option. There is no limit to how many members an LLC may have, and it is also possible to just have one member. The obvious upside to this type of legal business entity is that it provides the best parts of both worlds, corporation and non-corporation, but the downside is that it is more difficult to file than a partnership (but is still less difficult than forming a corporation). To date, the federal government does not recognize an LLC as a classification when you file your federal taxes, so you must file either as a sole proprietorship, partnership, or corporation.

So What do I do Now?

As with any kind of legal decision, deciding which business entity type is right for your business is a big decision that requires a lot of thought. This is just an overview of the primary differences between each major legal business entity, so before making a decision, check with your lawyer or accountant to decide which is best for your financial and business interests. It seems complicated at first, but once you get registered with the state, you’ll be on your way toward owning and operating your own business!

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Starting With the Right Legal Business Type, Partnership

Having spent time working in several countries, across 3 continents, one of the business types I have found to be commonly used to trade under, is a Partnership.

The thing about partnerships though is that there appears to be various forms of this type of business available depending on which country you live in. In some instances even the state or province you trade in will affect the options available to you.

Noting the significant differences between the available types of partnerships, I would strongly suggest that you discuss your options with your local accountant and lawyer in some detail before starting out. Making sure that your business meets your specific needs in this instance is especially important.

Despite the significant differences there are a few common traits, that are specific to this type of business, including:

1. Two or more people doing business together under the same name.

This is naturally the most common characteristic of this type of business. You and a friend want to start a business together, this may be the type of business for you. In most locations it is possible to register a trade name for your partnership, and it may even be possible to register your partnership as a separate legal entity. Make sure to explore your options thoroughly as your financial wellbeing may well depend on it.

2. Governed by a partnership agreement.

Though it is possible to setup a partnership type business without a partnership agreement, not having an agreement would be like dropping yourself in the middle of the ocean with no hope of rescue. The reality is that when money is involved, people tend to change, and often these changes have devastating affects on both your relationship with your partners, and your business.

In fact, no matter what type of partnership you start, make sure that there is a clear partnership agreement that defines everything from investment required to sharing of liabilities and assets, in the event of dissolution. Defining partner duties and obligations in this agreement as well, may just save your business in the future. And of course in doing so, make sure to be specific.

3. It is usually relatively easy to dissolve.

If your partnership was not registered as a legal entity it is usually easy to dissolve from a legal perspective. You can simply stop trading in your partnership name and terminate your partnership in the manner defined by your partnership agreement. Notably though if the partnership is a legal entity this may be a little more difficult.

One practical consideration that often complicates dissolution of partnerships would be distribution of assets and liabilities (debts). Questions like who will keep the client list or the office location if the partnership is dissolved, will often become hugely disputed issues, and so it is especially important to define asset and liability distribution in your partnership agreement. My suggestion is to treat the partnership agreement like a prenuptial agreement. It is easier to define this aspect upfront when you and your partners are on good terms, than trying to sort it out when you are not.

4. Personal liability could be limited, unlimited or even somewhere in between.

Depending on the partnership type it is important to realize that in the worst of these, you could be responsible for debts your partner incurs, even without your knowledge. This means that if your partner makes a mess, you could lose your house as well.

Notably there are various types of Partnerships available and depending on your location, levels of liability may vary from total, all the way through to hardly any. It is thus essential that you get proper advice to ensure that you are comfortable with what you are buying into. Also understand that no matter the partnership type you get involved in, a very high measure of trust between partners is essential to ensure long standing success.

5. You are unable to sell the business, you can only sell the assets

Since the partnership usually depends on two or more people working together, it is often hard to sell that relationship. Your old partners would have to accept the new partner, and the new partner would have to accept the terms of your existing partnership agreement, which I might add, would prove very complicated from a legal perspective. Also in most cases partnerships are not legal entities and so the only option is to sell the assets of the business, which may include good will, client lists and usually some physical assets.

This is of course further complicated if one partner wants to sell, and the other does not. A dissolution and subsequent distribution of assets is often the natural outcome of this type of situation.

6. Taxation is usually based on a personal tax model.

Notably since most of the partnerships are not separate legal entities, the profits of a partnership are taxed as if personal income. Unfortunately due to the various types of partnerships, establishing your individual tax liability and how it is calculated will significantly depend on how your partnership is set up. Be aware though that in some arrangements, the tax man could hold you responsible for the unpaid taxes of other partners.

In conclusion it is easy see that this type of business is varying and potentially complex. And though often easy to set up, partnerships are usually established when things are going well, often ignoring the potential pitfalls completely. This then result in significant headaches and often insurmountable challenges down the road, when things are not going as well. And since there are other options available for doing business, my advice would be that you rather consider an alternative, if at all possible.

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