CHOOSING A TYPE OF ENTITY FOR YOUR NEW BUSINESS
One of the most important decisions you will make during the process of forming your new business is the type of entity the business will be. Choice of entity affects your legal liability in case of a lawsuit, the assets available to your business and to you as an owner, and how much income tax you will pay on revenues from the operation of your business. The following sections discuss the primary entity types used in forming businesses:
A sole proprietorship consists of one individual carrying on an unincorporated trade or business. The sole proprietorship has no legal existence separate from its owner, and requires no formation through state law. No sale of the business, as an independent business, is possible. A sale of the proprietorship is actually a sale of the assets of the proprietorship. All profits and losses of the business flow directly through to the owner as personal income. The owner is personally liable in full for all debts, obligations, taxes, and damages incurred by the business.
Advantages: Few legal restrictions, ease of formation, ease of termination, no registration requirement, no entity tax return to file.
Disadvantages: Unlimited personal liability, may not bring in new owners or outside capital contributions, profits cannot be reinvested in the business without tax liability to the owner.
A general partnership consists of two or more owners and carries on an unincorporated trade or business. The partnership may have a partnership agreement, but the partnership agreement is not mandatory. The partnership has no legal existence separate from its owners, and requires no formation through state law. Sale of a partner’s interest may be restricted by the terms of the partnership agreement, if one exists. All profits and losses of the partnership flow directly through to the partners according to their partnership interests, as modified by the terms of the partnership agreement, as personal income. The partners are personally liable in full for all debts, obligations, taxes, and damages incurred by the business. Partnerships file a tax return, but incur no entity tax liability.
Advantages: Easy to establish, multiple sources of capital and expertise.
Disadvantages: Partners liable in full for actions of all other partners, sharing of profits.
A limited partnership consists of two or more owners and carries on an unincorporated trade or business. A limited partnership differs from a general partnership in that only one owner, the general partner, is fully liable for all debt obligations, taxes, and damages incurred by the business. The other owners are limited partners, and are liable only in the amount they invested in the business. Like a general partnership, the existence of the partnership is only outlined in the partnership agreement, and no documentation is filed with the state. All profits and losses flow through to the partners according to their partnership interest, as modified by the terms of the partnership agreement, as personal income.
Advantages: Limited partners are protected from full personal liability.
Disadvantages: General partner retains full personal liability, partnership agreements can be extremely complex, particularly in terms of selling partnership interests.
A C corporation is an entity formed under state law, which has its own legal existence distinct from that of the stockholders. Corporate formation requires filing of complex legal documents with the state. The stockholders have no personal liability for debts, obligations, taxes, and damages incurred by the corporation beyond the amount they invested in the corporation’s stock. Sale of ownership interest in the corporation merely requires sale of the stock owned by the stockholder. As a distinct legal entity, the corporation’s income is owned by the corporation, and may be held by the corporation without creating tax liability for the stockholders. Any profits distributed to the stockholders are subject to double taxation, once on the corporation at the entity level, and once to the stockholders for their share of the profits received.
Advantages: Limited liability for all owners, relative ease of raising capital through stock and bond issues, ease of sale of ownership interest.
Disadvantages: Complex formation, double taxation of any profits that get distributed to stockholders, high degree of governmental regulation compared to other entity types.
An S Corporation is a corporation meeting certain IRS requirements as a “small business corporation." Unlike a regular C corporation, profits and losses from an S corporation flow through to stockholders as if they were partners in a partnership. The flow-through of profits to stockholders avoids the problem of double taxation. S corporations have limitations on the number of stockholders (currently, an S corporation may have no more than 100 stockholders), and another corporation or a foreign-owned entity may not be a stockholder in an S corporation.
Advantages: Limited liability for all stockholders, no double taxation on distributed profits, relative ease of capital formation through stock and debt issues.
Disadvantages: Stockholders pay tax on the business’s earnings even if the business does not distribute any of the earnings to the stockholders, limitations on who can be a stockholder.
Limited Liability Company
A limited liability company, or LLC, is an entity with attributes of both partnerships and corporations. Like a corporation, an LLC is formed under state law through the filing of documents, and limits the liability of all members to the amount of their investment in the business. The formation of an LLC is less formal than that of a corporation, in that under the laws of most states, corporations must file extensive documents containing very specific information, while an LLC may file a formation document containing whatever agreement is reached by the members, similar to a partnership agreement. Like a partnership, all earnings of the business flow through to the members, even if there is no distribution of the business’s profits to the members. Sale of a member’s interest in the LLC can be difficult, and is often restricted by the terms of the LLC agreement. Although a single member can form an LLC, the single-member LLC will be treated as a sole proprietorship for tax purposes.
Advantages: Less formal formation process than corporations, no double taxation of distributed profits, limited liability.
Disadvantages: Members pay tax on the business’s earnings even if the business does not distribute any of the earnings to the members, more complex formation process than partnerships.
What's your next step?
Obviously, this is a broad-brush treatment of a highly complex topic. Certain types of professional business, such as a doctor's office or a law firm, have other types of entity that are more specifically focused on that type of business. Also, each state may have specific requirements for certain entity types, particularly corporations. When forming a new business, it is always best to seek the advice of an attorney licensed in the jurisdiction in which you wish to operate the business.
PLEASE NOTE: This legal guide is intended to be used for informational purposes only. No attorney-client relationship, either express or implied, is created by the use of this guide, and this guide does not constitute legal advice form the author to any specific person in any way.
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