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Business Entity Types Explained

Overview of Different Business Entity Types

If you are thinking of starting a new business, or restructuring or incorporating an existing one, you may be somewhat perplexed as to which corporate entity type to choose.  Since each type has its own pros and cons, let’s take a look at those to help provide some insight.

Sole Proprietor: A sole proprietorship is owned and operated by one person. This is the simplest and least expensive business structure to form. Many start-up companies choose this form until it becomes practical to enter into a partnership or to incorporate. As the sole owner, all profits go to you, as do the losses! Your business profit and loss is recorded and is transferred to your personal tax form.

Pros:

  • Easy to form, hardly any restrictions and very few forms to fill out.
  • Control of profits.
  • Control of decision making and flexibility.
  • Less government control and simpler taxation.

Cons:

  • As a sole proprietor, you are responsible for 100 percent of all business debts and obligations.
  • The death, physical impairment, or incapacitation of the owner can result in the termination of the business.
  • It is typically more difficult for sole proprietors to raise operating cash or arrange long-term financing.

General Partnership: General partnerships are formed by two or more legal entities (any kind of legal entity can be partner), and each of those entities are individually responsible for the partnership. Each partner is personally liable for the partnership’s debts and legal liabilities. For tax purposes, all partners are considered self-employed and claim their share of the partnership’s income on their individual tax.

PROS:

  • Combined assets and expertise and flexible decision making.
  • Partners, not partnership, taxed at the individual level.
  • Business expenses deductible.
  • Ease of formation and low startup cost.
  • All the income generated by the business flows through to the owners.

CONS:

  • Partnership terminates on death or withdrawal of any partner.
  • Each partner is individually liable for agreements made by any partner.
  • The partners are held personally liable for business debt or damages.
  • Both income and management is shared among all the partners.

Limited Partnership: A limited partnership is much like a general partnership in structure. The main difference is that in a limited partnership, there are two different kinds of partners: general and limited. A limited partner does not take part in the management of the partnership and is not liable for any more than his individual capital investment.

Pros:

  • Limited partners are not personally liable for the partnership’s debts and obligations.
  • Partnership does not dissolve with death of limited partner.
  • Number of partners/owners unlimited.

Cons:

  • Transfer of interest usually requires general partner approval.
  • Complete and separate paperwork filings.
  • Limited partners have little, if any, control over daily operations.

Limited Liability Company: A limited liability company (LLC) is essentially a hybrid of a corporation and a partnership. An LLC provides the same kind of tax and liability benefits as a corporation, but has the same management structure as a partnership.

Pros:

  • Lacks the formalized requirements of a C-Corp but has the same liability protection.
  • Taxed on your personal income only.
  • No limit on the number of LLC members, and anyone can be an owner.
  • Under IRS “check-the-box” rules a limited liability company may choose whether to be taxed like a partnership or a corporation.
  • Members are compensated using either distributions of profit or guaranteed payments.
  • Possible to convert an LLC into a corporation.

Cons:

  • LLCs cannot go public or issue stock.
  • Active members are subject to self-employment tax for Social Security and Medicare.
  • It cannot raise money through the sale of stock.
  • Each member’s pro-rata share of profits represents taxable income–whether or not a member’s share of profits is distributed to him or her.
  • As a member of an LLC, you are not allowed to pay yourself wages.
  • Some states do not allow the organization of LLCs for certain professional vocations.

S-Corporation: An “S” corporation is much like a “C” corporation in that it is also its own legal entity, protects its shareholders from legal liability, and requires a significant amount of effort and money to start and maintain. However, an “S” corporation allows shareholders to claim their share of the corporation’s income directly on their personal tax return.

Pros:

  • The profits and losses of the business pass through to the corporation owner’s personal income tax. Like a Limited Liability Company, the tax “pass through” allows you to avoid “double taxation”.
  • Reduce Taxable Gains: Selling your business can be part of your retirement strategy. An S corporation could have reduced taxable gains when the business is sold.
  • S corporations offer protection against liabilities. However, liability protection is not complete protection.

Cons:

  • One Class of Stock: Not having the ability to issue different classes of stock affords a business less control over the company and limitations on the stock value.
  • Passing income through to shareholders can be a disadvantage in some instances. If the business is profitable, shareholders will be required to pay income tax on their share of the profits, even when not distributed to them.
  • Even though losses pass through to shareholders in an S-Corporation, those losses aren’t deductible by shareholders who don’t materially participate in the business.
  • May not own subsidiaries, which can make expansion difficult.

C-Corporation: A “C” corporation is a standard state-formed corporation. It is a legal entity once it is formed, so it files its own taxes and is responsible for its own dealings. A “C” corporation can have unlimited numbers of shareholders, and those shareholders can be any kind of legal entity. Corporations are the most expensive kind of business to begin and maintain.

Pros:

  • Ideal for a business trying to attract public acquisition and venture capital.
  • Can have an unlimited number of shareholders.
  • Shareholders are protected from the corporation’s liabilities.
  • Health insurance premiums and group life insurance up to $50,000 in benefits are fully deductible by the corporation and not taxable to the employees.

Cons:

  • C-corps have to abide by many requirements, such as holding meetings of a board of directors and keeping minutes, maintaining bylaws, and filing formal paperwork.
  • Taxed as a separate corporate entity, so in addition to your personal income taxes, you will have to pay corporate taxes.
  • Double taxation-the corporation pays taxes on its income and the shareholder pays taxes on dividends.
  • Shareholders cannot deduct the losses of the corporation.

If you are unsure which type is right for you, speak to a qualified accountant, consultant, or tax professional to help you make the right decision for you and your business.

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