Michael Goldman & Associates, L.L.C. - Consulting
& CPA Services
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Choosing
the Right Entity for your Business
One
of the first choices an entrepreneur must make when starting a business is to
decide which type of entity to establish. The choices include sole
proprietorship, general partnerships, limited partnerships, corporations,
S-corporations, and limited liability companies. While selecting the right type
will not guarantee success, choosing the wrong type can increase the likelihood
of failure. In
most cases, the two biggest issues in choosing an entity are (1) the probability
of incurring liability and the need for liability protection, and (2) the need
for capital to fuel growth. Other issues include your management structure,
capitalization, profitability projections, transferability of ownership,
administration, and tax issues. Here are the seven basic entities from which you
may choose, along with some of their advantages and disadvantages. Proprietorships
are easy to form and administer and do not exist for tax purposes (the income is
considered as yours, not a company’s). They may have limited sources of
capital and management resources. Proprietorships do not protect you from any
liability issues and while you can sell the assets of the business, there is no
separate business to sell or provision for continuity beyond the original owner.
Owners pay self-employment taxes. There are no formal state registration
requirements. If you are the sole owner and do no make any choice of entity,
this is the default choice. Businesses often start this way and “grow” into
one of the entities listed below. General
Partnerships
have more people involved than proprietorships, which usually gives them
greater access to capital and management. They have less administrative burdens
than corporations. Taxes can be allocated to the partners that can best use
them, all taxes flow through to the individual partners, and there is generally
no tax at termination. General partnerships do not provide liability protection,
taxation can be complex, and partners are subject to self-employment taxes.
There are no formal state registration requirements.
If two or more people own the business together and do not choose an
entity, this is the default choice. Trusts
can be taxed as a trust (highest tax rates), a corporation (possibly the lowest
tax rates) or a partnership (individual tax rates). There is no limited
liability and the life of the trust is limited. The major benefit of a trust is
that it can provide greater secrecy, and possibly protection from future
creditors, than the other entity types. Limited
Partnerships
are similar to general partnerships, except that they allow some partners to be
passive investors that can limit their liability to the extent of their
investment. State laws generally require formal registration to protect the
limited liability status. Corporations
pay income taxes at lower rates than individuals do, but if the owners are not
careful, the income can be double-taxed (both at the corporate and the owner
level). Unlike people, corporations have unlimited life spans; and it is easy to
transfer their ownership. The owner’s liability is limited to his or her
investment. Corporations find it easier to raise capital, because shares can
usually be freely bought and sold. Administrative rules must be followed for
corporations, or else the corporation can be considered dissolved, and all its
benefits will be voided. A company can be incorporated in any state, but it must
be registered with the state in which it does business, and it has practically
all the rights and obligations that people do under state law. S-Corporations
are a special type of corporation set up for tax purposes. The income or loss
flows through to the owners, eliminating the double-taxation problem of regular
corporations. If the owners take a reasonable salary, they can receive
distributions from the corporation that are not subject to payroll taxes. In
exchange for the tax benefits, the IRS imposes a number of restrictions on who
can be owners, how many owners there can be, the choice of fiscal year, and the
deductibility of fringe benefits for shareholders. Flexibility of attributing
income or losses to the various owners is also severely limited. Liability
protection and rights under state laws are the same as for regular corporations. Limited Liability Companies were created to combine the tax advantages of a partnership with the liability protection and flexibility of a corporation. There are few ownership restrictions and none of the S-corporation restrictions. On the other hand, the complex tax rules of partnerships apply. Ownership interests are harder to sell than are shares in a corporation, and laws governing LLC’s vary from state to state. Liability is limited to the member’s investment, which facilitates the raising of capital. A single member LLC can exist for legal purposes, but does not exist for tax purposes. Keep
in mind that failure to follow the administrative regulations of your state
could pierce the liability shield set up by your entity, and that inadequate
planning could prove disastrous from a tax standpoint. Be scrupulous in keeping
your personal affairs separate from those of your entity (have separate bank
accounts, separate accounting systems, document your activities, etc.), or your
entity may be considered not to exist in a legal dispute. Different entities are used to achieve different combinations of objectives, so it is important to have a good idea of exactly what you want to accomplish and what risks are involved. To narrow the choice, focus on your key objectives. Meet with your financial and legal advisers for advice on selecting the entity that is right for your business.
© Michael Goldman 2000 For more information, please go to www.michaelgoldman.com Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser. |
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