What type of entity should you choose for your business?

When it comes to starting a new business, the most important step is deciding about the type of legal entity for the business because your decision will affect the amount of taxes you pay, the personal liability protection you will have and the amount of paperwork you should do to maintain your business structure.

The Most common types of business are
• Sole Proprietorships
• Corporations
• S Corporations
• Limited Liability Companies (LLCs)
• Partnerships

Sole Proprietorships:
A sole proprietorship is the most common form of business chosen to start a business. It is an unincorporated business structure that is owned and run by one natural person and in which there is no legal distinction between the owner and the business.

Advantages of a Sole Proprietorship
A sole proprietorship is the simple and cheapest way to form a business. The costs are at the minimum level and limited to obtaining the required licenses and permits to run the business. Because the owner and the business are the same, the business itself is not taxed separately. The income and/or losses and expenses of the sole proprietorship are business owner’s income, losses and expenses and reported to IRS with the owner’s tax return (Form 1040, Schedule C).

Disadvantages
The biggest drawback of the Sole Proprietorships is the unlimited personal liability. Since there is no legal distinction between the owner and the business, the owner may be held personally liable for the debts and obligations of the business and liabilities resulting from the acts of employees.
It is also really hard to raise money for the business because banks are hesitant to lend to a sole proprietorship which is only based on owner’s self-credibility, investors can’t invest in your business because the sole proprietorship can’t sell stocks.

Corporations
A corporation (sometimes referred to as a C corporation) is an incorporated business structure formed under the laws of the state in which the business is located. A corporation is an independent legal entity owned by shareholders.
Advantages of a Corporation
Unlike Sole Proprietorships, the owners (called shareholders) of the corporation are not personally liable for the debts and obligations of the business.
Corporations files taxes separately from owners, and have an advantage to raise additional capital through the sale of corporate stock and banks are usually tend to offer loan to corporations.

Disadvantages.
Compare to other business structures, corporations are costly to form and start-up. The income of the business is taxed at corporate tax levels and they are sometime subject to “Double Taxation” meaning the corporation is taxed when it makes a profit and the owners (shareholders) are taxed when they receive dividends from the corporation.
The Corporations should also pay attention to their recordkeeping requirements. Shareholders must hold annual shareholder meetings and keep minutes of the meetings and file annual or biennial statements with the state.

S Corporations
Shareholders of Corporation (C Corp) may however avoid double taxation by electing to be treated as an S corporation allowing income or losses to be passed through to their individual tax returns (Pass- through tax system).
Shareholders must file the Form 2553 with IRS to elect “S” status within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect. They must also make “S” corporations election with the state where it is headquartered.

Advantages of S corporation
With the pass-through taxation system, profits and losses are passed through to owner’s personal tax return meaning, only the owners are being taxed not the business itself thus it may lead serious tax savings.
Because S Corporation allows business owners to separate themselves from the business itself, it shields owners from creditors and lawsuits seeking financial compensation from the corporation. Shareholders are also not personally responsible for the business debts and liabilities of the corporation absent an express personal guarantee.

Disadvantages
In S corporations, shareholders who works for the corporation must receive “reasonable compensation.” Basically, a shareholder must be paid at fair market value standards, otherwise IRS may reclassify any additional corporate earnings as “wages” resulting with higher employment taxes.
In S corporations, the foreign ownership is prohibited. Each shareholder must be a U.S. citizen or resident.
Also, S corporations can have only one class of stock and cannot be more than 100 shareholders.

Limited Liability Companies (LLCs)
A limited liability company is a hybrid (mixture) between a corporation and a partnership. It provides many of the same legal and liability protections available to corporations, and the tax efficiencies and operational flexibility of a partnership.
Unlike a corporation, an LLC is not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each owner (called members) of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnerships.

Advantages of an LLC
Members’ personal assets are usually exempt from the debts and obligations of the LLC. This is similar protection as corporations.
Business is not taxed at corporate level instead pass-through system as explained above. LLCs also offer less recordkeeping with smaller start-up costs, and there are less restrictions on profit sharing. Members can distribute profits when they see fit and can allocate profits and or losses at different percentages among them.

Disadvantages
In the LLCs members have “limited” liability meaning members are not necessarily protected from wrongful acts, including the wrongful acts of their employees.
Because Members of an LLC are considered self-employed, members must pay the self- employment tax towards Medicare and Social Security which is usually high. The entire net income of the business is also subject to self-employment tax.
Sometimes it may be hard for an LLC to find investors when it comes to raising additional capitals as LLC can’t offer sale of stocks moreover, certain business cannot be formed as an LLC such as banks and insurance companies.

Differences between LLCs and S Corporations
One big difference between S corporations and LLCs is the tax savings for the business. While members of an LLC are subject to self-employment tax on the entire net income of the business, whereas only the wages paid to employee/ shareholder of an S corporation are subject to employment tax. If there is remaining income paid to the shareholders as a “distribution,” that is taxed at lower rate.
A limited liability company may be owned by individual (s), corporation(s), other LLCs and foreign entities but shareholders of an S corporation must be individuals (not partnerships or corporations) who are U.S. citizens or permanent residents. Moreover,  S corporations cannot have more than 100 shareholders.
Another difference is that LLCs have less record keeping requirements and ongoing expenses than S Corps formation and ongoing expenses. Generally speaking, limited liability companies do not have to maintain corporate requirements. In some states, LLC s are only required to file a biennial statement with the Secretary of State but S corps must keep meeting minutes, a board of directors, officers, separate business accounts and appropriate records for all of their business transactions. S corps also pay annual report/ franchise taxes to the state.
On the other hand, it is possible that an established LLC may choose to be taxed as “S Corporation” by filing the Form 2533 with IRS. By doing so, LLC remains a limited liability as a legal structure but becomes ‘S Corporation” as a tax standpoint.

Partnership
Partnership is a type of business organization where two or more people pool money, property, labor or skill, and share profits and losses of the business.
Partnerships file Form 1065 with IRS (U.S. Return of Partnership Income) to report income and expenses. Each partner reports his share of the partnership net profit or loss on his personal IRS Form 1040 tax return.
General partners pay self-employment taxes on their net earnings from the partnership and Limited partners pay self-employment taxes only when they received professional fees for services rendered.

Advantages of a Partnership
Partnerships are easy to form and they are generally an inexpensive business structures. Pooling resources to obtain capital is helpful raising money and expanding business.
Disadvantages
The biggest disadvantage of the partnership is the joint and individual liability. Like sole proprietorships, partners are jointly and personally liable for the debts and obligations of the business plus debts and wrongful decisions made by other partners. Moreover, partner’s personal assets can be used to satisfy the partnership’s debt when partnership assets are
insufficient.
On the other hand, a partner cannot transfer interest in the business without the unanimous consent of the partners.
Also, a partnership may be dissolved if one partner wants to withdrawal from the business or dies making it unstable business structure.

Conclusion
As discussed above, all corporations, LLC’s, and partnerships have unique advantages or disadvantages over the other. What type of business format should you chose actually depends on your specific situation. You should consult an experienced and licensed attorney to have an idea as to which structure will best suit your particular situation and needs.

By Metin Caglar, Esq./Published in Business-Corporation Law articles
Contact Caglar Law Firm, P.C. to schedule a free consultation.