Choosing the Right Entity Type For Your New Business

Choosing the right entity type for your new business is an important decision that can affect your personal liability, tax implications, and the ease of conducting business. This article helps to answer questions about the advantages and disadvantages of choosing different forms of ownership when starting a new business. It is important to identify the characteristics of different forms of ownership. There are tax and nontax implications for the different forms of ownership.

When the decision to launch a new business is made, the participants must choose a legal form of entity. Available options include sole proprietorships, general partnerships, limited partnerships (LPs), limited liability partnerships (LLPs), limited liability companies (LLCs), C corporations, and S corporations.

Although selecting the right entity cannot ensure success, selecting the wrong entity can prove costly. Since each of these business forms has characteristics that are favorable or unfavorable to the taxpayer, the practitioner is in a unique position to provide valuable guidance on this decision.

All choice-of-entity planning engagements should include two basic steps:

1. Identifying the goals and
2. Developing and coordinating a strategy to fulfill those goals.

Entity selection affects sources of equity funding but not debt financing. However, lenders will lend to a business based on the creditworthiness of the business and its owner(s).

Other than the sole proprietorship, all business entities are separate from the owner. As a separate entity, the business may enter into contracts, sue, be sued, and own property in its own name.

Some people arrive with preconceived expectations of the form of entity they should use or are only focused on one aspect of entity selection such as minimizing taxes. Some new entrepreneurs lack business sophistication, e.g., are entering their first business as an owner, they may need extensive guidance regarding which business structure is most appropriate.

What are the objectives in choosing a company structure?

There are the following objectives to be considered in choosing a company type.

Tax Savings

The tax costs of operating a new or existing business are often a major concern of its owners. The proper entity type can minimize combined self-employment and income taxes. Understanding the overall tax situation – business and personal income tax, payroll tax, and estate tax exposure – is essential in finding the best entity choice.

Limitation of Liability

Some people’s main objective is often personal liability protection. Proprietorship or general partnership classification offers no liability limitation to the owners/partners. Limited partnerships, limited liability companies, limited liability partnerships, S corporations, and C corporations may provide the partners/shareholders with liability protection depending on the owners’ personal involvement in the business activities, the involvement of employees, lenders’ requirements of personal guarantees, and the application of professional service malpractice statutes. An owner may still be liable for illegal actions made on behalf of an entity with limited liability.

Business Incorporation Options

Management

A common reason for an entrepreneur to start a business is to be able to be the primary decision-maker. The degree to which one person may make all decisions, or the manner in which the responsibility to make decisions is split among a group, can depend on the ownership structure of the business.

If more than one individual owns equity in a business, it cannot be run as a sole proprietorship. If all owners will provide management services, a limited partnership is not a viable option since limited partners cannot provide management services without jeopardizing their status as limited partners. Other entity types offer limited liability to owners involved in management.

Motivation

Most new entrepreneurs have different motivations for creating and managing their businesses. Some people want to create a business that will grow large enough to have an initial public offering and be sold on a national stock exchange. These business owners may select an entity that simplifies the transition from a private to a public company or simplifies the process of obtaining outside investment.

Some entrepreneurs start businesses to share their dream or passion with others. They are most focused on ensuring that the theater continues after their death.

Some owners do not have large dreams of growth and simply want to create a family business that is respected in the community and provides a steady cash flow. These owners may select an entity with low taxes that can be continued by family members. Features such as the ability to obtain outside investment may not be needed or are less important.

Ownership Transition

In many cases, a change in entity status is sought to accomplish a transition in ownership. Whether the objective involves moving ownership to a successor via gifts, installment sale, stock redemption, bequest, or a combination of methods, it is often necessary to utilize a different form of entity to meet client objectives.

What are the main advantages and disadvantages of each type of entity?

Each company type has its own advantages and disadvantages. Let’s review the pros and cons of each entity type.

Sole Proprietorships

Sole proprietorships are the most basic and (usually) simplest form of business organization. All new businesses with only one owner default to a sole proprietorship. The sole proprietorship is not a legal entity separate and apart from its owner. In a sole proprietorship, the owner holds title to the property, conducts business for profit, and is directly and personally liable for all obligations of the business.

In most cases, the owner’s personal assets can be seized to satisfy sole proprietorship debts.

Self-employment income is generally earned by a sole proprietor or independent contractor from a trade or business. A sole proprietor generally reports all self-employment income and expenses on Schedule C.

A deduction from gross income is allowed for all ordinary and necessary expenses paid or incurred during a tax year in carrying on a trade or business. These deductions apply to sole proprietors as well as other business entities.

A trade or business is a regular and continuous activity that is entered into with the expectation of making a profit. “Regular” means the taxpayer devotes a substantial amount of business time to the activity. An activity that is not engaged in for profit is a hobby (personal). An activity that results in a profit in any 3 of 5 consecutive tax years (2 of 7 for the breeding and racing of horses) is presumed not to be a hobby. Expenses related to a hobby are not deductible, but any income is included in gross income.

Self-employment tax

Self-employment taxes are paid through estimated payments, not withholding. Net income from self-employment does not include the following:

1. Rents
2. Gain or loss from the disposition of business property
3. Capital gain or loss
4. Nonbusiness interest
5. Dividends
6. Income or expenses related to personal activities
7. Wages, salaries, or tips received as an employee
8. Self-employment tax
9. Self-employment health insurance

State and local taxes imposed on the net income of an individual are not deductible on Schedule C. They are deductible as a personal, itemized deduction and are not a business expense of a sole proprietorship. Federal income taxes generally are not deductible. Individual taxpayers may claim an itemized deduction for either general state and local sales taxes or state income taxes, but not both.

Advantages include the following:

• They are easy to form since they have few filings, elections, and registrations. Sole proprietorships can do business in any state without having to file, register, or otherwise qualify to do business in that state.
• They are simple to operate. For example, the owner manages the business and reports to no one.
• It is easy to sell the assets of the business.
• It has the fewest administrative burdens.
• For tax purposes, income is generally passed through to the owner and taxed only at the personal level.

Disadvantages include the following:

• Sources of capital may be limited since a sole proprietor cannot raise equity capital other than the personal resources of the proprietor.
• The owner has unlimited liability with respect to the activities and operations of the sole proprietorship. This means that the owner’s personal assets are exposed without limitation to any and all liabilities related to the business.
• There is no structured continuity if the proprietor cannot work.
• All business net income is subject to self-employment tax.

General Partnerships

General partnerships are associations of two or more persons as co-owners to carry on a business with the intention of making a profit (even if no profit is earned). All new businesses with multiple owners default to a general partnership. An advantage of the general partnership is that it can exist without

any formalities. No filings are required, and a partnership may be created without an explicit agreement (oral or written) or even an intent to form a partnership.

Although an intent to form a partnership is not required, the co-owners must intend to make a profit even if no profit is earned. A person who receives a share of the profit is assumed to be a partner, however, this assumption is overcome if the amounts received are as payments for debts, principal or interests, rent, wages, etc. If the elements of a partnership are present, it is formed even if the parties do not intend to be partners.

Under the Statute of Frauds, a contract (e.g., a partnership agreement), the performance of which cannot be performed within 1 year of its making, must be in writing or proper electronic form to be valid.

• For example, a contract to create a partnership for a specified 2-year period must be in writing.

Partnerships are entities separate from their owners. The co-owners personally share the risks and rewards of all phases of the business. There is flexibility when writing the agreement to specify how the risks and rewards will be shared specifically, if at all. For example, partners choose how gross receipts will be shared and may have a partner who is not entitled to the partnership’s annual income.

Advantages include the following:

• They have more sources of initial capital than sole proprietorships.
• There generally are more management resources available than for sole proprietorships.
• Each partner has a right to equal participation in the management of the partnership.
• They have fewer administrative burdens than corporations.
• For tax purposes, income is generally passed through to the partners and taxed only at the personal level. Income and loss allocations can be flexible, and termination can generally occur without immediate taxation.
• Partnership property is owned by the partnership and not by the partners. Thus, a partner cannot assign or otherwise transfer partnership property.

Disadvantages include the following:

• The transfer of ownership interests is frequently difficult.
• Each partner is personally liable for all partnership obligations (i.e., all general partners are jointly and severally liable for partnership torts). There is no liability limitation unless the partnership is a limited liability partnership. Minority partners can be held accountable for 100% of the partnership’s debt.
• Generally, all business net income of a partnership is subject to self-employment tax even if the partner who receives the income is not personally active in the partnership.
• Partnership income tax and basis adjustment rules can be complex, particularly with respect to transactions between a partner and a partnership.
• Partners are entitled to very few of the tax-deductible fringe benefits that are generally available to employees.

A joint venture is an easily formed business structure in international commerce. It is an association to accomplish a specific business purpose or objective and is often organized for a single transaction. No statute requires a filing to create a joint venture. In most cases, a joint venture is treated as a partnership.

 Qualified Joint Venture Exception

This exception permits a qualified joint venture, whose only two members are spouses who file a joint return, to not be treated as a partnership for federal tax purposes. A qualified joint venture is a joint venture involving the conduct of a trade or business if

1. The only members of the joint venture are legally married,
2. Both spouses materially participate in the trade or business, and
3. Both spouses elect not to be treated as a partnership.

All items of income, gain, loss, deduction, and credit are divided between the spouses in accordance with their respective interests in the venture. Each spouse takes into account his or her respective share of these items as a sole proprietor. Each spouse would account for his or her respective share on the appropriate form, such as a Schedule C.

For purposes of determining net earnings from self-employment, each spouse’s share of income or loss from a qualified joint venture is taken into account just as it is for federal income tax purposes.

Limited Partnerships

Limited partnerships (LPs) are a special type of partnership with similar tax rules to regular partnerships (all partnerships are pass-through entities in which the owners pay taxes on their share of income).

The main difference is that limited partnerships have at least one limited partner who is not personally liable for any of the partnership’s liabilities. This form of organization is a legal device that enables limited partners to be passive investors in a partnership. In exchange for not having any future liabilities (i.e., a limited partner in a limited partnership may only lose what (s)he invested into the partnership), limited partners are not able to participate in the day-to-day management and operations of the limited partnership. General partners in limited partnerships can still manage and control day-to-day operations, but they retain unlimited liability. There must be at least one general partner in a limited partnership.

Corporations

Corporations are entities created under state law with the purpose of conducting business. They are characterized as artificial persons which means they can hire employees, enter into contracts, acquire assets, and incur liabilities. An important feature is that they generally enable their owners to limit their liability to the extent of their investment in the corporation. For taxes, corporations are normally split into two types based on the governing subchapter of the Internal Revenue Code. The IRS treats all corporations as C corporations by default; all corporations listed on stock exchanges are C corporations. Certain corporations meeting specific requirements may elect to be treated as an S corporation.

 C Corporations

The original form of corporation in the United States is the C corporation. C corporations can have unlimited shareholders in any country.

Entities that are classified as C corporations for federal tax purposes are subject to an entity-level income tax. In addition, when a C corporation distributes its profits to its owners as dividends, the owners are subject to income taxation on the dividend income they receive. This “double” taxation is the hallmark of C corporation status.

The computation of taxable income for C corporations is similar to that of individuals. Gross income is broadly conceived (unless excluded by a code section) and then taxpayers are allowed various deductions before arriving at the taxable income upon which the income tax is computed. From the total tax liability, a taxpayer can subtract their prepayments and tax credits before arriving at the amount due or refund due. And, like an individual, a corporation must make estimated tax payments throughout the year.

However, C corporation tax calculations have several important differences.

First, properties held by C corporations are guided by special rules upon formation and are treated differently than the property of individuals.

Second, C corporations do not use the concept of adjusted gross income (AGI); therefore, there are no below-the-line or above-the-line deductions.

Third, C corporations are not allowed credits or deductions of a personal nature (e.g., the standard deduction or the Child Tax Credit). Also, unlike the progressive tax rate schedules used for individuals, C corporations are taxed at a flat rate of 21%. A C corporation tax return is made on Form 1120, U.S. Corporation Income Tax Return.

Advantages include the following:

• There is a practical method to raise capital through the sale of capital stock.
• Owners have limited liability.
• Corporations have unlimited lives unless the articles of incorporation provide for a shorter life.
• A corporation is considered a person for most purposes.
• It is relatively easy to transfer ownership interests.
• They generally have more management resources.
• Owner-employees generally may receive the full array of employer-provided tax-free fringe benefits.
• Shareholders can be individuals, estates, partnerships, or other corporations.

Disadvantages include the following:

• They are subject to double taxation. Annual net income and gains on the distribution of appreciated assets are taxed at the corporate level. Subsequent dividends, liquidating distributions, or redemption payments are then taxed to the owners, creating a double tax on such distributions.
• Double taxation can be avoided by paying all the corporation’s income to owners in the form of compensation.
• They have more administrative burdens.
• They are more difficult to form, and dissolution can trigger taxable gains.
• Borrowing may be difficult without stockholder guarantees, which negates part of the advantage of limited liability.
• Loss on the sale of stock normally represents a capital loss subject to the capital loss limitations on the shareholder returns. Ordinary loss treatment may be available for qualifying small businesses (Sec. 1244).
• Reduced individual control of a business operated by managers, not owners.

S Corporations

S corporations are hybrid corporations that combine some of the tax advantages of a partnership with the liability protection of a corporation. Start-up businesses often seriously consider S corporation status because owners can both avoid double taxation and limit liability.

An S corporation is generally not subject to a federal tax on its income. Its items of income, loss, deduction, and credit are passed through to its shareholders on a per-day and per-share basis. Each shareholder is taxed on his or her share of the S corporation’s income as it is earned. Distributions of cash or property generally are not income to its shareholders.

Advantages include the following:

• The double taxation affecting most C corporations is avoided because income is passed through to the shareholders for tax purposes, increasing the stock basis.
• Owners have limited liability.
• Distributions from S corporations are exempt from the payroll tax system, assuming the corporation issues adequate compensations to those shareholders performing services for the corporation.
• The Tax Cuts and Jobs Act allows a nonresident alien to be a current beneficiary of an electing small business trust (ESBT). An ESBT can be a shareholder of an S corporation.

Disadvantages include the following:

• The number of shareholders is limited to no more than 100. Family members are automatically treated as one shareholder for purposes of this limit.
• They can only have one class of stock.
• They cannot have any owners that are C corporations, partnerships, and certain trusts. They cannot have nonresident shareholders except as beneficiaries of an ESBT.
• They generally must choose a calendar year rather than a fiscal year.
• Shareholder employees owning more than 2% of the company must pay taxes on a wide range of employee fringe benefits that would be tax-free to an employee of a C corporation.

Limited Liability Companies

Limited liability companies (LLCs) are business entities created under state law that are owned by members and combine the tax advantages of a partnership or limited partnership with the liability protection of a corporation. All states have enacted legislation allowing for the creation of LLCs. All LLC owners, regardless of participation, receive limited liability. The owners of an LLC are referred to as members.

A single-member LLC can choose to be taxed as a sole proprietorship (disregarded entity) or as a corporation. A multiple-member LLC can choose to be taxed as a partnership or as a corporation. For example, LLCs that are accumulating working capital or building equity would elect to be taxed as

C corporations. Service or profitable LLCs that want to reduce self-employment taxes would elect to be taxed as S corporations because they are not subject to self-employment taxes. LLCs that incur losses or hold capital appreciation assets, e.g., real estate, and want to pass through losses and capital gains to owners would elect to be taxed as sole proprietors or partnerships.

Advantages include the following:

• Members have limited liability.
• The number of members is not limited.
• Members may be individuals, corporations, trusts, partnerships, other LLCs, and other entities.
• The double taxation affecting most C corporations is avoided. Income is passed through to the members for tax purposes under partnership principles.
• Members can participate in managing the LLC.
• Members generally are not personally liable for the LLC’s debts.
• Distributions to members do not have to be directly proportional to the member’s ownership percentages as they do for S corporations.
• They have the flexibility to structure ownership interests.

Disadvantages include the following:

• They may have limited life, often terminated on the death or bankruptcy of a member. However, most LLCs have unlimited life and dissolve only upon the vote of the members.
• Transfer of interests is difficult. Although a member may transfer an equity interest in the LLC, the new owner does not necessarily possess all of the rights and attributes of a member.
• Some industries or professions may not be permitted to use LLC statuses, such as banks and insurance companies.
• All states have enacted LLC laws, but the laws that have been enacted vary from state to state. Therefore, the LLC must determine how it will be treated for both tax and liability purposes when operating in multiple states.
• The various LLC laws are new and relatively untested in nontax matters, such as their actual ability to limit member liability.
• For tax purposes, the complex partnership rules generally apply.
• Members will often be subject to self-employment tax.

Limited Liability Partnerships

Limited liability partnerships (LLPs) are a special type of partnership that exist under applicable state law. They were enacted in response to the concern that a partner of a professional firm could be held liable for the malpractice of another party in the same firm. Hence, LLPs are typically adopted by providers of professional services (e.g., attorneys, CPAs, and physicians). LLPs are an alternative to LLCs in some states that do not allow professional firms to organize as LLCs.

An LLP is a general partnership with limited liability and is a favorable form of organization for professionals who have not incorporated. An LLP must file a statement of qualification with the secretary of state and in some states maintain professional liability insurance. All partners are general partners who have limited liability for the acts of other parties. In most states, liability is limited for all partnership obligations, including those resulting from contracts. Thus, a full shield statute imposes liability only to the extent of the LLP’s assets, with certain exceptions.

EXAMPLE: A partner remains liable for obligations s(he) personally guaranteed or incurred and for wrongful acts. Additionally, a partner who is an immediate supervisor also is liable for the wrongs committed within the scope of employment by an employee.

Advantages include the following:

• As partnerships, they have favorable pass-through taxation status.
• They have the flexibility to structure ownership interests.

Disadvantages include the following:

• In some states, the partners are liable for the debts and other obligations of the LLP.

However, most states give LLPs the same liability protection as LLCs.

Summary

You should now be able to answer questions about the advantages and disadvantages of different forms of ownership and identify characteristics of different forms of ownership. Starting a new business can be an exciting and challenging venture. It is important to be prepared for the challenges and hard work ahead. Choosing the right business entity type is crucial for your new business as it can have significant implications on your personal liability, tax obligations, and the overall ease of conducting business. It’s important to consider factors such as your business goals, funding requirements, and personal liability preferences when making this decision.